December Month in Review

Major U.S. equity indices rose to record highs in December, even as coronavirus infections continued to rise and other measures of U.S. economic health, including consumer spending and employment figures, printed at unfavorable numbers.^Footnote1 Despite a mixed short-term outlook, market participants appear to be gaining a more favorable long-term outlook as Americans begin receiving vaccinations and additional stimulus measures take effect. Meanwhile, the municipal market exhibited a continuation of seasonal dynamics, which began to take shape in November following the U.S. elections and have been characterized by relatively low supply and sustained demand.

In total, just $30.7 billion of new municipal issuance came to market in December, with taxable debt accounting for nearly $9.1 billion.* Even with the recent month’s relatively light calendar, however, total municipal issuance in 2020 exceeded $513.7 billion. This was driven in large part by the $184.9 billion in taxable deals – issued under both municipal and corporate CUSIPS – that came to market throughout the year. 2020 was a banner year for municipal issuance, as both taxable and total issuance climbed to the highest levels on record.^Footnote2 Five consecutive weeks of municipal fund inflows in December also helped drive yields down by 1-2 basis points (bps) across the AAA Municipal Market Data (MMD), with the 10-year tenor closing the year at 71 bps.^Footnote3

• December’s FOMC meeting marked the Federal Reserve’s final of the year. At the meeting, Fed policy makers reinforced guidance set in previous meetings for supporting the economy with large-scale asset purchases (quantitative easing) and near-zero short-term rates. Fed officials affirmed that asset purchases are to remain at their current levels and frequencies “until substantial further progress has been made” toward the Fed’s broader employment and inflation goals. Additionally a survey of Fed officials points to short-term interest rates remaining near zero for at least three years.^Footnote4
• Municipal bonds closed the year with an additional month of positive performance. The Bloomberg Barclays Municipal Bond Index returned 0.61% in December, while the Bloomberg Barclays High Yield Municipal Bond Index was up 1.87% and the Bloomberg Barclays Taxable Municipal Index gained 1.08%. Final returns for the year of 2020 for the three indices totaled 5.21%, 4.89%, and 10.52%, respectively.^Footnote5
• Treasury yields, with the exception of some shorter tenors, largely moved in the opposite direction as municipal yields in December. While Treasuries closed out the year with positive performance, they underperformed municipals in the month of December, leading to further tightening in municipal/Treasury taxable-equivalent spreads.** At month-end, taxable-equivalent spreads equated to 11 bps at the one-year tenor (down from 13 bps), 1 bps at the five-year tenor (down from 3 bps), 28 bps at the 10-year tenor (down from 38 bps), and 70 bps at the 30-year tenor (down from 80 bps).^Footnote6

Secondary market trade volume in December sprang back from its lowest level in more than a decade. Trades for the month totaled 657,000 (up from 549,000 in November) while par traded amounted to $193 billion (up from $159 billion).^Footnote7

Muni technicals in focus: Munis remain resilient, and taxable munis are here to stay

In a month largely characterized by an influx of negative news related to the pandemic and its effects on the U.S. economy, markets closed the final days of the year on a slightly more positive note. Optimism surrounding a second stimulus bill and COVID-19 vaccine rollouts propelled major U.S. equity indices to record highs, even as the United States grappled with increasing coronavirus infection rates and economic weakness.^Footnote8

As equities rallied, U.S. Treasury and AAA municipal yields experienced relatively little movement over the month. The U.S. Treasury yield curve underwent a bear steepener, with yields inside of three years flat or down by 2-3 basis points (bps), while yields at the 10-year tenor and beyond were up by 7-8 bps. Bolstered by seasonal supply/demand dynamics, the AAA MMD yield curve closed the month down by 1-2 bps at all tenors. The 10-year municipal/Treasury ratio closed out the year at 77%, only slightly higher than 2019’s final print of 75%.^Footnote9

Municipals remained resilient through the final days of the year, with sustained demand for the asset class even as supply remained relatively low. Municipal funds experienced five consecutive weeks of inflows through December, carrying total muni fund flows for the year to $39.7 billion.^Footnote10 Municipal credit spreads tightened over the month, helping drive the Bloomberg Barclays Municipal High Yield Bond Index’s 1.87% return.^Footnote11 That said, municipal credit spreads remain wide relative to their pre-pandemic levels and relative to current corporate credit spreads.^Footnote12 Taxable munis, which accounted for nearly 36% of 2020’s total municipal issuance, look to remain a dominant theme in the coming year. JP Morgan and Citi are each projecting nearly $200 billion in taxable sales for 2021, reinforcing the general belief that the recent surge in taxable issuance is part of a broader structural shift.^Footnote13

Pivoting toward municipal credit, state and local governments were largely left out of the recently passed stimulus bill. Mayors and governors are now left hoping for additional pandemic relief under a Biden administration, as state and local government aid remains a Democratic priority. The prospects for such legislation have improved following Democratic victories in the Georgia Senate races. We do not believe the lack of federal aid to state and local governments will result in a wave of municipal defaults, although it does complicate budget decisions for municipal governments that are confronting uncertain economic conditions. The lack of direct federal relief likely means growing austerity measures on the part of state and local governments. We have already seen states cut back on spending for the first time since the global financial crisis, with General Fund spending in Fiscal Year 2021 declining by 5.5% from pre-COVID budget recommendations.^Footnote14 This trend is likely to be exacerbated as states and cities craft budgets that currently assume no additional federal assistance.

Despite falling well short of the most optimistic hopes, the stimulus bill does carry with it some bright spots for the municipal market. While not seeing any direct aid, state and local governments’ tax collections and economies will benefit indirectly from the relief provided to companies and individuals. Sectors such as airports should benefit, as airlines are slated to receive $15 billion in aid, and hard-hit public transit districts that have seen broad ridership declines will receive $14 billion in assistance.^Footnote15 The bill also allocates $82 billion in new relief for K-12 school districts and higher education.

To learn more about investing in municipals at PIMCO, please visit pimco.com/munis