What Might Fuel Renewed Strength in Muni Bonds? | Lord Abbett
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Fixed-Income Insights

Our Director of Tax-Free Fixed Income assesses key trends and opportunities in the municipal bond market.

Read time: 5 minutes

After a positive start to the year, the municipal bond market encountered some headwinds in late February. As of February 24, the Bloomberg Barclays Municipal Bond Index posted a return of -0.73% while the Bloomberg Barclays High Yield Municipal Bond Index was up 1.27%. By comparison, the Bloomberg Barclays U.S. Aggregate Bond Index was lower by 2.20%.

The market action comes amid a rise in U.S. Treasury yields, which has been accompanied by some outflows in municipal bond mutual funds, based on data from Refinitiv Lipper, though we think the amounts appear modest at this point. We would note that the muni market typically has high costs for liquidity as fund firms sell bonds to meet investor redemptions in such an environment. In our view, the cost for liquidity is actually weighing on the market more than the climbing Treasury yields.

While the recent market action has dampened returns, we believe that the positive outlook for the broad municipal bond market we have expressed in recent months remains intact.  Here, we examine some important dynamics that we believe will support the municipal bond market in 2021.

  1. Supply/Demand Dynamics

Economics 101 typically covers how supply and demand changes affect markets, and the recent behavior of muni bonds provides an object lesson. On the supply side, the amount of new issue supply during 2020 appeared to be very high—$474 billion, according to The Bond Buyer. But that figure reflected a big increase in taxable municipal bonds; issuance of tax-exempt municipal bonds actually decreased from 2019. As we have noted before, the growth of taxable bond issuance reflects the continuing impact of the 2017 U.S. tax legislation, which now only allows issuers to refinance or refund outstanding bonds prior to their call dates with taxable bonds.

With rates falling, refinancings can lower borrowing costs, so issuers have been using taxable bonds to achieve this goal. This trend has continued in 2021 (through February 19), as about one-third of issuance has been taxable. Unless Congress amends the tax code, this change likely will stay in place.

On the demand side, interest in municipals has come roaring back after large outflows in muni-bond mutual funds in March 2020. Despite the March volatility, the $43 billion of net inflows in 2020 marked the fourth highest year for fund flows.1 The flows have gotten stronger in 2021 with $24 billion in the first one and one-half months of the year. One other interesting statistic is that for 2020, net flows into high-yield municipal bond funds were negative, but in 2021 they have been very positive at $4.5 billion, helping lead to strong performance in the lower-quality segment of the market.

  1. Credit Performance

The trends in municipal bond credit and investor sentiment towards taking credit risk over the past year have been unusual. For the first two (pre-pandemic) months of 2020, perceptions of credit quality were positive. Some people were thinking that there wasn’t much credit risk in municipals, and at least in the investment-grade market, not much research was necessary. Then the pandemic hit, and investor opinion completely reversed.

In the spring, there were constant questions about how it would be possible for municipal bond credits to survive. State and local governments forecast huge deficits. Market observers questioned things like how universities could stay afloat without having classes on campus, how airports could survive with fewer people flying, and how hospitals could be profitable taking care of COVID patients while not being able to perform higher-margin elective procedures. Suddenly municipals went from a market with perceived low credit risk to one rife with disaster scenarios.

Now, nearly a year into the pandemic, the disaster concerns have dissipated. We have seen some small rating downgrades, along with rating agency moves to negative outlooks on certain issuers, and a small increase in defaults in some pockets of high-yield municipals such as senior living, but overall things have held up well. Last April, the CARES Act provided fiscal support and the Federal Reserve’s Municipal Liquidity Facility provided a powerful psychological boost, in our view, even though only two issuers ultimately tapped the facility.

Tax revenues have not dropped anywhere near projections made early in the pandemic. For example, California has a budget surplus, and Illinois announced that it does not need to increase tax rates because revenues are sufficient. Most states are coming in with only a small decline in revenues. Another example of a sector where the gloomiest predictions did not come to pass is airports. While passenger volume is down about 65%, according to the Federal Aviation Administration, airports’ overall strong balance sheets, along with fiscal support from the federal government, has helped the sector weather the crisis well, in our view.

So, the broad municipal bond market remains a high-quality market proving its resilience through some of the worst-case scenarios for many sectors. Still, it is a market subject to credit risk and individual investor sentiment, so it is not always going to move in tandem with U.S. Treasuries, as the recent performance divergence of the two markets makes plain.

  1. Investor Preferences

With the cycle of major changes in consensus outlooks for municipal bond credit over the past year, investors have made their opinions clear by moving their assets around. As we noted earlier, during the first two months of 2020, there were strong flows into muni-bond funds. During March, flows reversed dramatically when there was uncertainty and confusion. Flows recovered from April onward, but a much higher proportion shifted into the high-quality portions of the market for most of the year. Following the news of effective vaccine treatments for COVID-19 in November, flows strengthened into all types of credit risk and maturities as outlooks have become more positive.

Going forward, it appears that investors will view municipals as a market subject to credit risk and therefore, different from U.S. Treasuries. That change in attitude has strengthened demand for municipals due to comfort with the investments and relatively attractive tax-equivalent yields compared to other fixed-income alternatives. But a higher portion of the flows appears to be going into professionally managed products such as mutual funds and separately managed accounts, indicating that investors prefer that professionals maintain surveillance over these investments.

Another reason why money is flowing to managed products is because dealer inventories are shrinking as they are not taking as much risk. Also, the supply/demand dynamics referenced earlier appear to be reducing secondary market volume, as there is not as much selling due to fund flows. For example, dealer inventories of bonds 10 years and longer were about $4 billion as of February 12, 2021, compared to $15 billion at the same time in 2017, according to Bloomberg data. When new issues do come into the market, they are typically heavily oversubscribed with all the bonds allocated and only a small portion available in the secondary market, usually only at higher prices.

Our Market Outlook

Here, we have outlined the most important market dynamics for 2021—but there are actually a number of other potentially positive impacts to consider for the year ahead. For example, the large fiscal stimulus is moving through Congress and appears set to provide a lot of money to state and local governments in addition to other government entities. With the vaccine now being distributed—and an end in sight for the pandemic—the consensus is that the added fiscal stimulus should be sufficient to help municipal issuers through whatever challenges may remain. Also, under the new administration, we think there is virtually no chance that U.S. tax rates will go down, which we think will provide support for the municipal bond market. If tax rates only go up for corporations, that may help the market as well, as it may restore demand from banks and insurance companies, who had been major buyers in previous years when corporate tax rates were higher.

These dynamics appear to have fostered optimism among investors, and we think they are the major reasons why the municipal bond market has been performing  well compared to other fixed income markets this year with most funds having slightly positive or close to unchanged returns for the year-to-date. Since the COVID vaccine news of November 2020, the lower-quality parts of the market have been coming on strong.

Still, we always approach the market with caution where there may be potential headwinds: The possibility that pockets of the high-yield market will continue to see small defaults; the potential for inflation expectations to rise more due to the fiscal stimulus which might continue to put pressure on the market as it has during late February, which might continue to push up interest rates; and credit-specific situations where downgrades might occur as certain areas of the economy may recover from the pandemic more slowly than others. These things make investors like us constantly re-review our investment outlooks to decide what to hold and what to sell.

Overall, these positive municipal bond market-specific attributes we’ve covered here appear to be in place for a while. We think they are likely to continue to have a positive impact on investment performance.

 

1All references to mutual-fund flows in this commentary are based on data from Refinitiv Lipper.

IMPORTANT INFORMATION

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, is a $2.2 trillion economic stimulus bill enacted in March 2020 in response to the impact on the U.S. economy of the COVID-19 pandemic.

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of the tax-exempt yield on a municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield. The tax-equivalent return on a municipal bond reflects the tax-equivalent yield and price changes on the underlying securities.

Bloomberg Barclays Municipal Bond Index: a rules-based, market-value-weighted index engineered for the long-term, tax-exempt bond market. Bonds must be rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.

Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of non-investment-grade, unrated or below Ba1 bonds.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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