AAM Viewpoints: Municipal markets get a shot in the arm as political tailwinds build
Q1 2021 started out much the same way as Q1 2020 for US municipal markets, beginning with strong performance early in the year, only to be followed by volatility and a move to the downside. Luckily, enough for municipal investors, the 2021 sell-off was something much more akin to a healthy correction driven by a backdrop of higher interest rates as opposed to the COVID-related credit capitulation that shook investors to the core in Q1 2020. In fact, a little more than a year removed from the beginnings of the pandemic and it appears the municipal market has come full circle. While broad municipals were down 0.35% through Q1 2021 due to sharply higher interest rates, they were also the best performing US investment grade fixed income class by a large margin. Municipals outperformed US Investment Grade Corporates by 430 basis points and were ahead of US Treasuries, which had their worst quarter since 1980, by 395 basis points. The foundation driving the outperformance remains intact moving forward and it would not be a surprise if the relative outperformance continued with absolute performance subject to fits and bouts should interest rates continue to rise.
There are several reasons for the continued demand in the space, some old some new. The market continues to be challenged by constrained supply, but is also supported by a healthy economic backdrop, which offers a combination of safety and income that is not matched by other areas of the market. Additionally, the end of the quarter brought support from a new arena as political tailwinds for the asset class came to fruition. Federal stimulus in the form of the American Rescue Plan Act of 2021 lifted a veil of uncertainty surrounding federal aid for state and local municipalities that had permeated the market discussion for much of 2020. Municipals responded in-kind and staged a late quarter rally with broad indices up 0.62% in March.
Prior rounds of federal stimulus did provide aid to municipalities, but it was either piecemeal (such as aid only for public education) or indirect (support for broader areas of the economy such as the airline industry). The latest round of fiscal spending, over half a trillion allocated to municipalities alone, is by far one of the largest rounds of direct aid to state and local governments in the history of the country. In fact, the sheer size of the overall package, $1.9 trillion, and the timing of the deal could have longer term implications, at least for the financial markets. It likely served as one of the catalysts for the increase interest rates in Q1 2021.
Markets already concerned about higher inflation viewed the legislation as adding fuel to an already hot economy. This reignited the “reflation” trade and pushed interest rates higher as markets digested the prospects of adding $1.9 trillion in new stimulus to an already bright macroeconomic environment as reflected in Q1 data. The third and final revision for Q4 2020 Gross Domestic Product was revised up to 4.3% from 4.1% to start the quarter. Additionally, although the housing market has slowed slightly, it is still running at a breakneck pace as the median price for existing home rose nearly 16% on a year-over-year basis in February, an all-time high. Moreover, consumer sentiment ended the quarter at the highest-level post-pandemic, jobless claims touched post-pandemic lows, and service sector survey data indicated the strongest service sector output expansion since 2014. Anecdotally, one need not look far to see the impact of how a year of COVID fatigue has produced pent-up demand to several of the more discretionary areas of the economy. Air travel, air fares, vacation, and vacation rental prices, as well as the cost to rent a vehicle all moved sharply higher in Q1 2021.
It would be hard to argue that the economic environment, along with the stimulus package, is anything but a credit positive for the municipal market. Total returns based on credit quality seem to support the narrative of a credit positive backdrop as Municipal High Yield was up 2.11% in Q1 2021. BBB rated bonds, up 1.28% on the quarter, outperformed the balance of investment grade credit qualities. In contrast, AAA rated bonds, typically more sensitive to interest rates, were down 0.90% and behind BBB bonds by a whopping 218 basis points. Q1 also ended with prospects for future political tailwinds with the announcement of the Biden Administration’s $2.5 trillion Infrastructure Plan that calls not only for an increase in corporate tax rates, but also increases the likelihood of higher individual tax rates on the country’s highest wage earners.
With a risk-on economic backdrop, a political climate that favors municipals and a credit backstop in place via recent federal aid, it is understandable that municipals should continue to see strong inflows. This foundation in place could continue to support relative outperformance versus the balance of investment grade fixed income markets for the foreseeable future. One would be remiss not to acknowledge the overhang created by the potential for higher interest rates. In simpler terms, you cannot have your cake and eat it too. Along with improving economic prospects and the potential for higher inflation comes higher interest rates which could be a drag on fixed income performance. With that being said, the recent relative outperformance of municipals in Q1 illustrates the resiliency of the asset class even in the face of higher interest rates. In a quarter with the longest dated treasuries down a staggering -13.5% and broad treasury indices suffering their worst losses in over 40 years, municipal investors would likely welcome modest losses of 0.35% any day of the week. We believe political tailwinds only strengthen the case for municipals as a safe haven of choice to weather the storm of higher interest rates.
CRN: 2021-0401-9062 R
An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.