An Early Spring Awakening in Munis
Key Insights
- Municipal yields reached historic lows in early February but have since followed Treasury yields upward.
- Resilient tax collections and federal aid could lead to cash windfalls for state and local governments, yet some issuers still face long‑term challenges.
- The potential combination of higher interest rates, fiscal support, and economic reopening is likely to present attractive opportunities, in our view.
While the municipal market has given back most of its year‑to‑date performance, we believe that its underlying credit strength has not changed. Moreover, the recent turbulence in the asset class has, in our view, presented attractive relative value opportunities in segments that stand to benefit from the likely tailwinds of federal aid and increased economic activity.
Following severe volatility last spring, strong technical tailwinds lifted the municipal bond market. Yields on high‑grade tax‑exempt bonds reached historic lows in early February 2021, fueled in large part by strong cash flows into municipal bond funds industrywide and constrained issuance of tax‑exempt debt. Concurrently, intense demand for additional yield helped drive credit spreads1 in some lower‑quality segments to below their pre‑pandemic levels.
In late February, however, strong early‑year gains for the broad municipal market were erased. Despite consistently dovish signals from the Federal Reserve, inflation concerns have led investors to pull forward their expected timeline for rate hikes, causing municipal yields to increase in sympathy with Treasury yields and both curves to steepen.
Fundamentals Showing Signs of Strength
We believe that the supply and demand imbalance that has driven the market’s performance over much of the past year is showing signs of stabilizing in the near term. Fund flows, which were positive for 40 of the 41 weeks between May 13, 2020, and February 24, 2021,2 have stalled alongside an anticipated uptick in new issuance in the spring. Outflow cycles tend to be correlated with rising Treasury rates, so we see potential for continued fund outflows amid further yield increases. However, the overall demand profile for municipals should remain intact as expected changes in tax laws are likely to increase demand for tax‑exempt income.
1.6%
Defying grim forecasts at the start of the crisis, state general fund revenues declined by a mere 1.6% during the fiscal year ended June 30, 2020.3
At the same time, we see indications that fundamental conditions, which have remained resilient throughout the pandemic, may be strengthening. Defying grim forecasts at the start of the crisis, state general fund revenues declined by a mere 1.6% during the fiscal year ended June 30, 2020.3 Subsequently, state and local government tax revenues in the third quarter of 2020 grew nearly 18% from the same period in 2019.4 As an example of improved state revenues, New Jersey—with its known fiscal challenges—recently announced plans to make a full payment to its pension system for the first time since 1996.
Year‑to‑Date Municipal Yield Changes
(Fig. 1) Muni rates tracked Treasuries higher in 2021
Past performance is not a reliable indicator of future performance. As of February 28, 2021.
U.S. Treasury yields are based on Bloomberg data, and municipal yields are based on the Municipal Market Data (MMD) curve from Thompson Reuters via Credit Scope.
Sources: Bloomberg (see Additional Disclosure) and Thomson Reuters. © 2021 Refinitiv. All rights reserved.
Should the pace of vaccinations continue to accelerate and lead to further improvement in the public health situation and a gradual easing of mobility restrictions, we expect additional growth in state and local government tax collections. We also see a strong likelihood that many revenue‑backed sectors that typically offer higher yields—such as transportation—will benefit from increased economic activity and any additional federal support.
Stimulus Could Deliver Windfalls to States and Localities
Coupled with better‑than‑expected tax receipts, market fundamentals have been bolstered by federal funding to many municipal borrowers through the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and other coronavirus relief packages. Direct fiscal aid to state and local governments has been a point of contention among federal lawmakers over the past year. However, Treasury Secretary Janet Yellen has highlighted state and local aid as a top priority for the new administration, and the latest federal stimulus bill—the American Rescue Plan Act of 2021 (American Rescue Plan)— provides roughly USD 350 billion to states and localities.5
The spending bill will also provide roughly USD 40 billion in aid for revenue‑backed municipal bond issuers, including airports, mass transit systems, and colleges and universities.6
Funding for states and localities should be much less restrictive than under the CARES Act. Notably, the American Rescue Plan will allow recipients to use funds to replace revenues that were lost, delayed, or decreased due to the pandemic, which should easily offset any revenue shortfalls they experienced over the past year.
Proposed Federal Aid for States
(Fig. 2) Potential funding based on our analysis of H.R. 1319
Figures in millions.
For illustrative purposes only.
In addition to fixed dollar amounts, the legislation will provide aid to states based on their unemployment rate, while cities and counties would receive supplemental funds based on their population size and poverty rate. Through these provisions, jurisdictions with above‑average unemployment rates due to strict lockdown measures should benefit disproportionately.
While further fiscal relief would be generally positive for the asset class, probable disparities in funding amounts across regions underscore the importance of fundamental credit research in the municipal market. Our dedicated team of credit analysts, in collaboration with the firm’s Washington, D.C., analysts, are carefully reviewing the text of the legislation to enhance our understanding of likely budget impacts for various issuers. Moreover, while direct federal support may serve as a short‑term reprieve for challenged municipalities, credit research remains vital in assessing which issuers will be able to address any long‑term financial challenges in a post‑pandemic world.
Still Cautious on General Obligation Debt
Historically, our municipal bond platform has been strategically underweight state and local government general obligation bonds, which are backed by the issuer’s ability to raise money through taxes. While healthy tax collections and significant federal stimulus would certainly leave many state and local governments in much better shape than feared at the onset of the pandemic, our positioning in the sector reflects our worries about the immense liabilities many of these issuers face due to underfunded pensions and retiree health care plans.
From a longer‑term perspective, we remain concerned about these fiscal challenges, which could be exacerbated by mounting pandemic‑related expenses. Over the short term, however, we see strong potential for states and select municipalities to reap cash windfalls—albeit to varying degrees—from the prospective economic reopening and fiscal aid package.
Uncertainty Warrants Careful Approach
We believe that uncertainty surrounding the direction of interest rates, along with signs of slowing demand and rising issuance, warrants a particularly careful approach, underscoring the importance of fundamental credit research. At the same time, the potential combination of higher interest rates, substantial fiscal relief, and economic reopening could present attractive opportunities for municipal investors.
"We believe that uncertainty surrounding the direction of interest rates, along with signs of slowing demand and rising issuance, warrants a particularly careful approach..."
Leading up to the recent sell‑off, our municipal bond platform had taken a more defensive stance by allowing duration to move toward a more neutral posture by letting cash accumulate and buying shorter‑duration bonds.7 In our view, this approach leaves us well positioned to deal with potential market weakness and to try to take advantage of opportunities should they arise. Amid the existing crosscurrents, we feel that in‑depth credit research is of increasing importance, and ultimately, we believe that our fundamental, bottom‑up approach should help our clients navigate the market environment.
WHAT WE’RE WATCHING NEXT
Our Washington research team believes that the Biden administration will shift its attention to its Build Back Better plan now that the American Rescue Plan has been enacted. Given the high price tag of this agenda, we feel that Build Back Better plan may be funded in part by increased personal and corporate income tax rates. While it is too early to forecast the impacts of such mechanisms on munis, increased tax rates have the potential to bolster demand for tax‑exempt securities.
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1 Credit spreads are the yield differences between higher‑ and lower‑quality bonds.
2 Source: JP Morgan Municipal Markets Weekly, based on Refinitiv Lipper data on weekly flows for municipal bond mutual funds and exchange‑traded funds.
3 Source: National Association of State Budget Officers, Fiscal Survey of States.
4 Source: U.S. Census Bureau, Quarterly Summary of State and Local Government Tax Revenue for Third Quarter 2020.
5 Source: H.R. 1319, American Rescue Plan Act of 2021.
6 Source: H.R. 1319, American Rescue Plan Act of 2021.
7 Duration measures a bond’s or a bond portfolio’s sensitivity to interest rate changes.
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1 Credit spreads are the yield differences between higher‑ and lower‑quality bonds.
2 Source: JP Morgan Municipal Markets Weekly, based on Refinitiv Lipper data on weekly flows for municipal bond mutual funds and exchange‑traded funds.
3 Source: National Association of State Budget Officers, Fiscal Survey of States.
4 Source: U.S. Census Bureau, Quarterly Summary of State and Local Government Tax Revenue for Third Quarter 2020.
5 Source: H.R. 1319, American Rescue Plan Act of 2021.
6 Source: H.R. 1319, American Rescue Plan Act of 2021.
7 Duration measures a bond’s or a bond portfolio’s sensitivity to interest rate changes.
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Additional Disclosure
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The views contained herein are those of the authors as of March 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall. Investments in high‑yield bonds involve greater risk of price volatility, illiquidity, and default than higher‑rated debt securities. Some income from the Funds may be subject to state and local taxes and the federal alternative minimum tax. All charts and tables are shown for illustrative purposes only.
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