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Credit strength drives full muni bond recovery
- A flattening yield curve with declining interest rates enabled longer-maturity bonds to outperform.
- Low municipal-to-Treasury yield ratios reflect investors’ preference for municipal bonds so far this year.
- Federal funds, along with the reopening of the economy and a v-shaped revenue recovery, have created a strong catalyst for credit upgrades.
Looking back over the last 15 months, we think it is fair to say that the municipal market has fully recovered from the pandemic. After the reopening and reflation, investors are looking for a new theme. We believe federal policy changes and infrastructure spending could provide that catalyst.
Quantitative easing should be ongoing throughout the year, providing liquidity to fixed income markets.
Treasury yields shift downward
While the 10-year Treasury yield remains 55 basis points (bps) higher for the first half of the year, the yield trajectory has shifted downward. The yield declined off its highs by 27 bps during the second quarter in an environment of rising growth and inflation. Why?
The Fed is still dovish. Despite a tweak to its perspective in June, the central bank believes that inflationary pressures will prove temporary. It will allow the recovery to continue so that unemployment can decline further. Quantitative easing should be ongoing throughout the year, providing liquidity to fixed income markets.
Stimulus bills have been scaled back. A smaller infrastructure package will likely take most of the rest of the year to complete and win passage. Another mega stimulus package appears far less likely. This moderated fiscal stimulus will improve U.S. deficit levels, compared to expectations and last year’s aggressive spending.
Inflationary pressures increase sharply
As the U.S. economy reopens, financial markets are intensely debating the word transitory. The Fed correctly predicted that inflation would increase during reopening, and it expects these pressures to ease by sometime next year once the inevitable shortages are corrected.
Demand has increased rapidly, thanks to a successful U.S. vaccination campaign and generous federal stimulus checks. Supply has struggled to keep up in some sectors, in part because nearly eight million fewer workers are employed versus pre-pandemic times. To complicate matters further, some global supply chains are clogged as other countries lag the U.S. in their progress fighting the pandemic.
Many industries boosting CPI and PCE statistics, such as travel and automobiles, are experiencing labor or materials shortages that should eventually diminish. For example, while demand for leisure travel exceeds levels just prior to the pandemic, flights have been cut due to lack of staffing. U.S. GDP is running similar to pre-pandemic levels, albeit with eight million fewer workers, which indicates rising productivity.
It is too early to determine how long this inflationary environment will last, but financial markets appear to be discounting a lower inflation rate next year. More sidelined workers are reentering the labor market, a trend we believe will accelerate in the second half of the year. Stimulus spending in 2022 should significantly moderate year-over-year. Finally, secular trends that have supported the disinflationary environment over the last two decades – global competition, aging demographics and improving technology – will remain once the global economy returns to normal.
Short-term money market rates, as represented by SIFMA, have declined to 2 bps and don’t show signs of rising. Any increase would be due to a change in Fed policy, and the Fed is anchoring the short end of the yield curve very close to zero. Fed forecasts show the next rate increase cycle not beginning until 2023. Even in today’s low interest rate environment, value can still be added by leveraging the municipal yield curve, which maintains an upward slope of approximately 150 bps.
Value can still be added by leveraging the municipal yield curve, which has an upward slope of 150 bps.
The municipal market remains strong
The municipal market continued to outperform other fixed income asset classes in this favorable environment of falling rates, accommodative Fed policy and supportive technicals.
The benchmark AAA MMD yield has risen from 0.71% to 1.0% year-to-date in the 10-year portion of the yield curve, although high quality yields fell during the second quarter. Overall, the interest rate environment for AAA paper has proven fairly benign in 2021. The focus of the marketplace, and the opportunities for investors, has been in credit.
After steepening during the first quarter, the yield curve experienced a bull flattener during the second quarter as interest rates fell on all maturities except for years 1 and 2. The flattening of the yield curve and declining interest rates caused longer-maturity bonds to outperform those in shorter maturity ranges.
Municipal-to-Treasury yield ratios remain historically very low, after reaching historical highs in 2020. The 10-year municipal-to-Treasury yield ratio moved from 64% to 66% during the second quarter, versus a long-term average of 85%. The 30-year ratio dipped into the 60% range during the quarter, but ultimately ended the quarter steady at 70% compared to a long-term average of 93%. These low ratios indicate municipal outperformance, driven by both technical and fundamental factors.
New issuance is up 8.5% year-to-date over last year, when the second quarter 2020 saw light issuance in the early days of the COVID-19 pandemic, followed by an increase as demand for bonds returned to the market over the summer. In 2021, April and May issuance was up while June was down slightly. Second quarter issuance is up 33% year-over-year and refundings are down 21.3%. Taxable municipal bond issuance is 5.4% higher year-over-year.
Fund flows have been consistently positive, at $8.95 billion, $5.67 billion, and $9.26 billion in April, May, and June, respectively. High yield flows for April, May, and June were $3.32 billion, $2.37 billion, and $2.44 billion respectively.
Credit spreads continued narrowing and the yield curve flattened 28 bps during the quarter. AAA municipal yields decreased up to 25 bps, with most movement 22 years and longer. BBB-AAA investment grade spreads narrowed from 79 to 63 bps, tighter than the long-term historical average of 102 bps. High yield municipal spreads are now 177 bps over AAA, compared to the historical average of 256 bps. Compression might slow, given the pre2008 financial crisis historic average was 189 bps.
Defaults total $1.1 billion year to date as of the end of June. This remains a very small percentage of the overall market. Since 2019, defaults have been cumulating mainly in the senior living/nursing homes, development and medical/hospital sectors.
We do not anticipate widespread municipal payment defaults going forward. In fact, ratings agencies have reversed course in the wake of the American Rescue Plan Act, moving most municipal sectors from negative outlook to stable or positive outlook. As a result, we anticipate a sharp improvement in the ratio of upgrades to downgrades this year.
Fiscal stimulus boosts municipals
It is hard to overstate the importance of the American Rescue Plan for municipal credit quality. Federal funds will continue to flow to municipalities, schools and transportation facilities (to name a few) over the next 18 months to 2 years. These funds, along with the reopening of the economy and the v-shaped revenue recovery, have created a strong catalyst for credit upgrades.
Lower-rated general obligation (GO) debt is already reaping the benefits. Illinois has been the highest performing area of the municipal bond market year-to-date. Both Moody’s and S&P upgraded the state’s GO credit, moving the state a notch further away from high yield. This contributed to substantial credit spread narrowing for state GOs, as well as the city of Chicago, the Met Pier & Exposition Center, the Board of Education and other lower-rated names.
Infrastructure spending has implications
Over the past few weeks, the likelihood has increased that an infrastructure spending package and accompanying tax reforms should pass through Congress. In June, a bipartisan group of senators reached an agreement with the Biden administration to provide $600 billion in new funding for traditional, physical infrastructure projects.
We anticipate a sharp improvement in the ratio of upgrades to downgrades this year.
The current proposal funds surface transportation (road/bridges/rail); airports; ports; public transit and water, power and broadband infrastructure projects. The agreement does not include funding for many of the social safety net programs or climate initiatives included in the administration’s $1.8 trillion American Families Plan proposed earlier this year.
While positive, this bipartisan effort may ultimately prove unattainable and insufficient. Many Democrats want to see a broader spending package, and compromise seems unlikely on the tax reform measures required to fund a larger spending plan. A single bill that is advanced through the budget reconciliation process, supported by only Democrats, is a possible alternative path forward. Congressional action is not expected until the fourth quarter of 2021, but confidence is building that a package could pass before year end.
Current proposals have meaningful implications for municipal issuers and investors. Some measure of deficit spending is inevitable, as tax policy reforms are unlikely to generate sufficient revenue to pay for the entire menu of spending. President Biden proposed increasing the corporate tax rate to 28% from 21%. But more moderate Democrats will likely keep the final rate closer to 25%, which could generate revenue of up to $400 billion. Tax rate increases are possible for multinational corporations, individual personal income taxes and capital gains.
The infrastructure spending package may contain number of measures that could directly impact the municipal bond market.
Many plan details have yet to be fleshed out, including a number of possible measures that could directly impact the municipal bond market. Higher tax rates support demand for tax-exempt municipal issuance, but other expected policy changes may end up increasing taxable supply. A new Build America Bonds program and an accompanying federal tax subsidy could generate new taxable municipal bond supply, depending on the magnitude of the subsidy. Analysts have estimated new taxable supply between $1.3 and $2.2 trillion. A direct federal subsidy program along the lines of the former Build America Bond program could displace some supply that would otherwise have come as tax exempt.
Other measures could increase tax-exempt supply. There is strong support for restoring tax-exempt advance refundings, perhaps as part of the infrastructure legislation. This would increase tax-exempt new issue supply while boosting bond calls and pre-refundings. Any roll back of current state and local tax (SALT) deduction caps (not contemplated in the current proposal, but still important for many members of Congress) could lower some individuals’ effective tax rates in high tax states, but we expect other factors to offset the impact of any changes to SALT deductions.
Puerto Rico anticipates fiscal surplus
Like most states and municipalities, Puerto Rico has benefitted from significant federal aid over the last year. Recent COVID-relief funding comes on top of $83.5 billion of federal disaster relief funding in response to the 2017 hurricanes, most of which is still being deployed. This unprecedented federal aid, and the recent uptick in economic activity has positively impacted government revenues.
Puerto Rico’s 2021 fiscal plan, certified in April, incorporated updated forecasts to account for the short-term income effects of relief aid and stimulus funds spending. The fiscal surplus over the plan period (2022 to 2026) is estimated at $6.7 billion. But over the longer horizon, the board still projects a deficit without structural reforms. Puerto’s Rico’s real GNP is projected to increase by 3.8% in FY21 before moderating to 1.5% growth in FY22.
The board approved the FY22 budget in July, the first budget to comply with the certified fiscal plan. This marks a significant milestone for Puerto Rico, as the oversight board’s authority will diminish once Puerto Rico adopts four consecutive balanced budgets. The $21.4 billion consolidated budget is the first to be agreed upon by the board, governor, and legislature, and starts the clock on the board’s future exit. However, to remain compliant, the budget will have to include debt service following the anticipated conclusion of the central government’s bankruptcy.
Puerto Rico’s momentum toward exiting its Title III bankruptcy process continues, but the path through a few remaining hurdles is not yet clear. While the oversight board has reached consensual agreements with many creditors, a few important holdouts remain. In addition, the board’s disagreement with the government over pension cuts included in the current debt adjustment plan also presents a challenge.
The next important step in the court process is a disclosure statement hearing scheduled for mid-July. A fourth amended plan of adjustment was filed at the end of June and additional revisions are expected as agreements are reached with the government and other creditors. Creditors are expected to vote on the plan later this year.
Investors should brace for some uncertainty over the balance of the year as the board and government move through the end of the debt restructuring. The complexities of creditor negotiations and inevitable political posturing will likely generate negative headlines and possible delays, but the process is moving forward. The bankruptcy process for the electric utility, PREPA, is not expected to resume in earnest until the central government bankruptcy has been completed, likely in 2022. The board plans to file a plan of adjustment for the Highway Authority in 2022 as well.
State revenues have been very resilient, outperforming virtually anyone’s expectations from one year ago.
State and local tax revenues make gains
State governments received 0.5% more in total tax revenue during the 12 months ended 31 Mar 2021, compared to the previous 12 months. While this increase is tiny, state revenues have been very resilient, outperforming virtually anyone’s expectations from one year ago. Revenue from individual and corporate income taxes grew by 4.4% and 5.6%, respectively, while sales tax receipts slipped by -1.2%, for a net gain of 2.1%. Local property tax revenue expanded by 5.3% over the same period. Certain additional state excise taxes dropped sharply, including revenue from motor fuels down -8.4% and the sale of alcoholic beverages down -3.9%.
In 2021, the American Rescue Plan provided an additional $219.8 billion for state governments, $130.2 billion for local governments and $122.8 billion for schools. This amount equals 29% of the total state and local tax revenues received during the 12 months ended 31 March 2021. Further, the CARES Act in March 2020 provided $150 billion to state, local, territorial and tribal governments, and the Consolidated Appropriations Act in December 2020 provided $54 billion for K-12 education and $22 billion to the states for COVID testing.
This substantial federal support comes on top of overall resilient municipal revenues, which are further enhanced by reopening. Viewed in combination, the 12-month turnaround of municipal credit has been impressive.
California water systems manage another drought
After enjoying several drought-free years, Governor Newsom declared 41 of California’s 58 counties to be in a drought on 10 May 2021. In contrast to the previous drought in 2015, no statewide emergency has been declared, nor have California residents been mandated to cut water usage.
Even though conservation measures lead to reduced water consumption and sales, that doesn’t necessarily weaken debt service coverage. To help manage through these conditions, systems can use tools including increasing rates, so strong customer service area wealth levels are important to absorb any necessary increases. Additionally, systems can structure rates to shield from a decline in water sales due to variations in the availability of water, such as implementing a higher base charge.
Water systems can be impacted in various ways and to varying degrees. Location and access to a different mix of water supply and storage options matters. The size of the system also matters, as the larger ones are typically more sophisticated and better equipped to manage any revenue disruption.
These conditions are not new to California water systems. Most have strong proactive management and typically fare better than water systems that do not have alternate plans. Management strategies include reinvesting in water storage infrastructure and alternative water supplies. Water systems plan, engineer and use technology to keep access to water.
California state law requires large water suppliers to prepare an urban water management plan detailing how they would respond to both a multiyear drought and a single year cutback of up to 50% in their available water supplies. The plan is updated every five years. Some systems have even turned to emerging technologies such as desalination to offset any water shortages. Winter may bring additional rainfall and may help alleviate water supply issues.
The length and severity of the drought also comes into play. Clearly, the longer the drought persists, the greater the potential for fiscal stress. Generally, water utilities are entering the current drought on strong fiscal footing with solid debt service coverage and liquidity. According to Moody’s Investor Service, U.S. water utilities median debt service coverage was more than 2.2x and median liquidity of 427 days cash on hand in 2019. The strong liquidity gives systems the financial flexibility to guard against any unforeseen events and delays the need to increase rates.
Wide-scale defaults are not expected, as water systems provide an essential service on a monopoly basis. However, downgrades could occur to systems that are not prepared for the impacts of the drought.
Wide-scale defaults are not expected in California’s water utilities, as water systems provide an essential service on a monopoly basis.
American Dream sees continued progress
The American Dream mall has seen continued progress in its opening, with good demand for waterpark and other entertainment options. Nearly 100 retail tenants are now operating, with more than 20 food and dining venues also available. According to disclosure reports, leasing of in-line retail declined to 76% during the second quarter (from 84%), mainly due to removing the leases of defunct retailers. Continued build-out and opening of leased spaces is expected through spring 2022.
Despite the project‘s delay and temporary closure, it has been generating revenue to support series 2017 PILOT bonds through assessment payments on the project’s assessed value. The owner is currently appealing its tax assessments for 2019, 2020 and 2021, with the stated intention of completing its own appraisal of the property for the basis of potential settlement with the county. Hearings will likely continue through 2021 as the owner produces its own appraisal and parties engage in settlement negotiations. Any adjustments resulting from appeal would require support from reserves, but ultimately assessed valuations are expected to reflect the full value of construction (with reserves sufficient for any funding requirements on the debt at this time).
The series 2017 grant revenue bonds are supported by a 75% pledge of sales tax receipts on qualifying purchases at the mall. Given space completion and tenant occupancy delays (18 to 24 months behind initial developer projections), sales tax receipts are anticipated to miss projections for the near term. Also, the structure of collections and distribution by the county has caused additional delays between sales and revenue distribution to the Trust Estate (two to four quarters). Draws from reserves are expected to fund a majority of the interest payment on the grant revenue bonds due 01 Aug 2021.
First quarter sales activity showed signs of advancement for both retail and entertainment activity. According to the developer, more than 100 additional tenants are in progress toward opening this year, with a number of tenants advertising September 2021 openings. At completion, the project is planned for 450 shops across 1.3 million square feet of retail space (45% of the total 2.14 million). Continued additions of retail and restaurant tenants to generate increased gross sales revenues are needed to fully support the series 2017 grant revenue bonds.
The vaccination and reopening progress has been critical to advancing this project, which appears to be gaining momentum. The bond structural features (including multiple types of tax liens, capitalized interest and reserve funds) have helped to pull this bond through the depths of the pandemic period without impairment or missed payments.
It should be noted that the mall owner has retained a financial advisor to address the $691 million senior construction loan and $475 million of mezzanine debt. Triple Five Group pledged a 49% interest in its Mall of America and 49% of its interest in West Edmonton Mall to both lenders on a first and second lien basis. Investors anticipate that these lenders will exercise rights on both facilities over the coming months. Both loans are subordinate to bond payments.
Overall credit is improving
Rich valuations are challenging in this high inflation environment, as they reduce a bond’s cushion to absorb future bumps in the road. Investors are wondering how long the good times can last.
High yield municipals have shown strong first half performance, amid spread compression and enhanced income levels. Lowered expectations for second half performance could mean income becomes the primary source of returns. This is not necessarily a negative for investors.
A potential infrastructure package could be market moving. Key issues and questions for municipals include the potential return of Build America Bonds and tax-exempt advance refundings, lifting the SALT deduction cap, and higher corporate and individual income tax rates. While some of these components may cut in different directions in the short term, most should provide longer-term benefits to the overall municipal market.
- 2021 is a transition year. The path to normalization is here and we believe it will ultimately be successful.
- The Fed and U.S. Treasury continue to support the markets, benefiting municipals.
- Monetary stimulus and low rates are boosting economic activity as conditions continue to stabilize.
- High inflation is a transitional concern and should trend towards the Fed’s target rate of 2% over time.
- Treasury yields have increased moderately. Technical factors and potential policy changes damp municipal bond sensitivity to rising rates.
- The essential nature of municipal projects proved to be a stabilizing factor throughout the pandemic.
- All sectors have been put on stable to improving outlooks. Overall credit has improved and should lead to more upgrades than downgrades.
- Volatility around tax changes and the infrastructure program will be the focus of the municipal market for the balance of the year.
Gross Domestic Product: U.S. Department of Commerce. Treasury Yields and Ratios: Bloomberg (subscription required). Municipal Bond Yields: Municipal Market Data. ICI Fund Flows: http://www.ici.org/research/stats. Municipal Issuance: Seibert Research. Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research. State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report. State Budget Reserves: Pew Charitable Trust. Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD). Standard & Poor’s and Investortools: http://www.invtools.com/. Flow of Funds, The Federal Reserve Board: http://www. federalreserve.gov/releases.pdf. Payroll Data: Bureau of Labor Statistics. Bond Ratings: Standard & Poor’s, Moody’s, Fitch. New Money Project Financing The Bond Buyer. State revenues: Bureau of Labor Statistics, National Association of State Budget Officers. www.calmatters.org, “Drought emergency declared in Central Valley, Klamath region.”-May 10, 2021. “Medians-Rate increases support stable financial metrics in 2019”, Water and Sewer Utilities-US, May 11, 2021, Moody’s Investors Service.
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A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a financial professional regarding their tax situation. Nuveen is not a tax advisor. Investors should contact a tax professional regarding the appropriateness of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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