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Munis remain steady as credit recovery gains steam
- Returns were slightly negative for high grades, but high yield and BBB bonds demonstrated positive returns as spreads narrowed.
- Federal stimulus could substantially boost credit and help accelerate spread narrowing.
- An infrastructure bill may provide additional catalysts to support the municipal market.
Municipal bonds proved resilient in the first quarter, with falling municipal-to-Treasury yield ratios and tightening credit spreads cushioning performance. Credit conditions continued to improve, supported by economic reopening and government stimulus. Demand remains strong, especially with potentially higher tax rates looming.
We think the 10-year Treasury yield now embeds most of what we anticipate for growth, inflation and deficit spending.
Good news is boosting Treasury yields
U.S. Treasury rates have been rising, but for positive reasons. First quarter GDP data is expected to show an economy expanding at an 8% to 10% annualized rate, COVID-19 vaccine rates are accelerating, daily cases have fallen sharply and warmer weather will help with reopening.
The 10-year Treasury bond yield has nearly doubled in 2021, increasing by 82 basis points (bps) from 0.92% to 1.74%. Similarly, the 30-year Treasury yield has increased by 76 bps from 1.65% to 2.41%. Most of the increase has been in 10-year maturities and beyond, as Federal Reserve (Fed) policy and near-term outlook have locked down the short end of the yield curve, causing it to steepen.
The future trajectory of inflation has become a hot topic across fixed income markets. Through February 2021, the annualized rate of increase in core inflation actually declined to 1.4%. However, most investors believe this level is temporarily depressed due to the pandemic. Anecdotes and purchasing managers’ surveys suggest that inflation is poised to pop as the economy moves to full reopening.
Prices of certain commodities, such as lumber and oil, rose during the first quarter on this feeling of optimism. The Fed considers this to be good news, and members of the Federal Open Market Committee (FOMC) have repeatedly said that an adjustment process will be necessary. Select price spikes may occur as reopenings create some temporary shortages, but these increases should be short-term and cyclical rather than secular.
We believe the secular forces that have been containing long-term inflation for more than a decade are unchanged post pandemic, if not stronger. In addition to the deflationary influence of technology, globalization and aging demographics, the economy remains far from full employment. The unemployment rate has declined to 6%, but millions of people have left the labor force, creating slack that will take time to fully absorb.
The economic rebound of 2021 is being fostered mainly by reopenings and promising vaccination rates. Additionally, the Fed is holding down short-term rates – the consensus view for the first increase is sometime during 2024 – and fiscal stimulus is coming with the American Rescue Plan. Since the $1.9 trillion spending plan (over two years) will not be funded by tax increases, fixed income markets have been wrestling with the $3 trillion deficit over the fiscal year and the resulting increase of U.S. Treasury bond supply
Both 10- and 30-year municipal-to-Treasury yield ratios are well below their long-term historical averages.
Given the optimistic outlook for economic growth, at least a temporary boost in inflation and heavy Treasury bond supply, Treasury yields are quickly approaching most of the existing year-end forecasts, which fall in the higher end of the 1.75% to 2.00% range.
We believe the recent move from a sub-1% yield was probably the most painful part of the normalization process for fixed income investors, and the 10-year rate now embeds most of what we anticipate for growth, inflation and deficit spending. We still envision Treasury rates edging moderately higher throughout 2021, but at a much slower pace.
How has this impacted municipal bonds?
High grade municipals are more sensitive to the general interest rate environment because they are more highly correlated to the AAA MMD curve and the Treasury markets. The 10-year AAA MMD benchmark yield has increased just half as much as Treasuries so far this year: 41 bps higher for 10-year MMD versus an 82 bps move for the 10-year Treasury. Similarly, the 30-year AAA MMD yield increased 36 bps to 1.75%, while the 30-year Treasury bond yield rose by 76 basis points to 2.41%.
This increase in high quality municipal bond rates pushed total returns slightly negative in the first quarter, although municipals still outperformed other fixed income asset classes.
This outperformance is naturally reflected in declining municipal-to-Treasury ratios. The 10-year ratio started the year at 76%, and is now as low as 64%. The 30-year ratio started at 84% and now sits at 73%. Both levels are meaningfully below their long-term historical averages.
Ratios are low for many reasons. Supply has been moderate, especially of tax-exempt bonds net of bond calls and maturities. Credit fundamentals have proven resilient, with revenues outperforming expectations and defaults remaining low. Just as full normalization of economic activity appears within reach, municipalities are receiving a large amount of federal government stimulus, further bolstering credit conditions. Demand for tax-exempt income remains high, and should grow with the increasing probability of some higher income tax rates in the coming year.
When it comes to generating positive performance amid rising interest rates, credit spreads have been a key contributor during the quarter and trailing 12 months. They provide a cushion of income, plus spread narrowing as rates increase and investors get more comfortable with the municipal credit outlook.
High yield municipals have benefited most from the combination of falling ratios and narrowing credit spreads.
Spreads started the year at attractive levels: +265 bps for high yield and +311 bps for short-duration high yield. That excess spread above historical averages is falling. Currently, high yield has declined to +218 bps, close to the pre-pandemic average, and short-duration high yield has fallen to +238 bps. We think this powerful trend will continue.
High yield municipals have benefited most from the combination of falling ratios and narrowing credit spreads. The Bloomberg Barclays High Yield Municipal Bond Index returned 2.11% for the first quarter, outperforming all major fixed income asset classes. This represents both income and modest capital appreciation. Interestingly, the total return of the 30-year Treasury bond was -20% late in the first quarter. Even in a bear market for Treasuries, certain municipals – particularly high yield – have generated positive returns.
In summary, lower ratios, tighter spreads, solid liquidity and modest supply are helping the municipal bond market.
Taxable municipal trend is firmly in place
Taxable municipal bond issuance was $26.9 billion in the first quarter, accounting for 23% of total municipal issuance. This percentage is a few points lower than in 2020, when taxable bonds accounted for more than 30%. Second quarter issuance is typically very large, and refunding activity could increase once the U.S. Treasury market stabilizes, potentially creating an environment for further growth in the taxable proportion of total supply.
Longer term, we believe the taxable municipal trend is firmly in place. The Fed has signaled that it will remain accommodative for the foreseeable future, which has kept foreign currency hedging costs low. Meanwhile, long-maturity yields have increased more in the U.S. versus many important fixed income markets in Europe and Asia. This has created a buying opportunity for foreign institutional investors who can take advantage of higher yielding municipal bonds relative to global developed nation sovereign debt with zero or negative yields.
In addition, taxable municipals are currently attractive to foreign institutions such as life insurance companies. This is mainly due to the scarcity of high quality, long-duration fixed income around the globe and the excess spread of investment grade municipals versus equivalently rated corporate bonds. With this demand backdrop likely to remain consistent, municipal issuers will likely continue issuing taxable bonds to diversify their buyer base and access the cost savings opportunities that come from refunding deals.
Infrastructure plan may benefit municipal bonds
President Biden’s recently proposed American Jobs Plan outlines an estimated $2.2 trillion in new infrastructure investment over the next decade. The expansive plan provides funding for traditional infrastructure projects like roads, bridges, public transit, clean water, airports, ports and modernizing school facilities. It also includes significant funding for clean energy, electric vehicles, affordable housing and expanding high-speed broadband access to rural areas. Funding for veterans’ hospitals, supply chain and manufacturing resiliency and investment in home health care round out the extensive list.
The municipal bond market ended 2020 on a high note, carrying that strength into January.
The plan would be paid for by increasing the corporate income tax rate to 28% from the current 21% and implementing several tax law changes for multinational corporations. The spending and tax increases in the American Jobs Plan are part of a larger, Build Back Better initiative.
Another $2 trillion worth of proposals for more social initiatives, or “human infrastructure,” is expected to be rolled out shortly under the American Families Plan. This will include funding for an expanded multiyear child tax credit, paid leave, childcare, universal pre-kindergarten, free community college and health care subsidies for the Affordable Care Act. Funding for this plan is expected to include a personal income tax rate increase, higher capital gains taxes and new social security taxes on high income earners.
Biden’s ambitious and sweeping plans are unlikely to have bipartisan support. A budget reconciliation process, similar to the way in which the American Rescue Plan was passed, is the most likely path forward. Democrats are willing to pass as much as they possibly can without Republican support, though some of the proposals, like setting a new clean energy standard, are not well suited to the constraints of reconciliation. These proposals are being introduced as large comprehensive packages, but smaller pieces of legislation will likely move forward separately.
While many provisions would impact the municipal market indirectly by driving economic growth and tax revenues, specific municipal bond provisions have not yet surfaced. Higher tax rates would pressure Congress to reverse current limitations on state and local tax (SALT) deductions as a concession. Reinstating tax-exempt advance refundings for municipal bonds may be included in new legislation as negotiations progress.
We could also eventually see authorization of new Build Back Better Bonds, which would be similar to Build America Bonds (BABs), featuring a federal subsidy to offset issuer borrowing costs. This would further accelerate taxable bond issuance.
Infrastructure is a perennial priority in Washington, D.C., but Congress has been unable to enact any meaningful or comprehensive funding in recent years. The Biden administration’s motivation to finally get something done may be extremely high, but it’s too early to predict which projects will win out and how much funding will be available from higher taxes.
Higher tax rates increase the relative value of municipal bonds, and we may see demand for municipals boosted considerably as some of these proposals are enacted. Congressional hearings and negotiations are expected to extend into early fall.
Municipal spreads have room to narrow
The municipal bond market ended 2020 on a high note, carrying that strength into January. The seasonal trend of light supply and strong demand set the tone for the month, with the Bloomberg Barclays Municipal Bond Index, a proxy for the market, returning 0.64%. In February, municipals demonstrated relative strength versus U.S. Treasuries, as rates rose and the yield curve steepened. The index returned -1.59% in February and 0.62% in March, for a quarterly return of -0.35%.
After flattening at the end of 2020, the yield curve remained stable in January, shifted upward and steepened in February, then municipal and Treasury rates stabilized in March.
Supply has been light thus far in 2021 at $106.9 billion. While this is a nearly 9% increase from this time last year, many deals had been postponed in March 2020 due to the pandemic. This is exemplified by year-over-year supply changes of -19.3% in January, -19.4% in February, and +112.9% in March.
The municipal-to-Treasury yield ratio has fallen this year. The 10-year moved from 76% to 64% and the 30-year moved from 84% to 73%. Historically, the 10-year and 30-year ratios are 85% and 93%, respectively.
Tax-exempt supply started the year slowly, then accelerated in March. The total of $79.4 billion was 21% more than the $65.7 billion issued in the first quarter of 2020. This is somewhat misleading, because municipal bond supply was extremely low in March 2020 due to the onset of the pandemic. Nevertheless, solid demand made first quarter 2021 issuance manageable, with issuance net of roll off of only $8.6 billion.
Taxable municipal bond issuance totaled $26.9 billion in the first quarter, or 23% of issuance, down from the fourth quarter. Many of these deals continue to be used for refunding tax-exempt bonds. Municipal issuers may be holding back on some larger deals pending more information about President Biden’s infrastructure plan. Borrowing needs seem to be moderating due to the improved revenue picture and the influx of federal dollars to municipalities.
March 2020 saw the worst month of municipal outflows on record at -$43 billion. Municipal fund flows turned positive in May and stayed positive through the end of the year. 2021 has started strong, with flows for January, February and March at $13 billion, $8 billion and $11 billion, respectively. High yield municipal flows for those months were $3 billion, $849 million and nearly $2 billion, respectively.
The yield curve steepened 40 bps during the quarter. AAA municipal yields increased up to 42 bps, with most movement at seven years and longer. Investment grade spreads narrowed from 108 bps to 78 bps, tighter than the long-term historical average of 102 bps. High yield municipal spreads ended the quarter at 209 bps, versus the historical average of 256 bps. Spreads could continue to narrow, as the pre-2008 financial crisis historic average was 189 bps.
Municipal defaults for 2021 totaled roughly $813 million at the end of March, with nursing homes and industrial development revenue bonds representing 74% of all defaults. This remains a very small percentage of the overall market. We do not anticipate widespread municipal payment defaults. In fact, given economic performance and the recent passage of stimulus, ratings agencies have improved their outlooks on most municipal sectors from negative to stable.
States and locals get a stimulus boost
The recently enacted $1.9 trillion American Rescue Plan Act will provide the first direct stimulus to state and local governments that is not required to be used specifically for pandemic response efforts. The expected aid is well above projected near-term budget gaps. State and local governments are set to receive $350 billion in direct aid over the next two years. Specifically, states will receive $195 billion and local governments will receive $130 billion, split evenly between cities and counties. Separately, local school districts will see over $120 billion in new federal funding and colleges and universities will benefit as well, with $40 billion earmarked for higher education. Significant funding of $30 billion for transit agencies is also included.
The direct stimulus spending changes the outlook for state and local governments, touching virtually every sector of the municipal market. The ARP Act also provides funding for a laundry list of initiatives: enhanced unemployment benefits, direct stimulus payments to individuals, rental and mortgage assistance, funding for vaccinations, expanded tax credits, childcare funding and other measures that will indirectly support tax revenues. This funding mitigates pressure on state and local governments to provide this support and will fuel tax revenue growth.
The amount of aid for governments is meaningful, especially in light of how well tax revenues held up over the last year. Though state revenues were projected to decline sharply in 2020, they were only down 2% in April through December of last year, compared to the prior year. Most states were able to manage budgetary stress without drastic measures. Many did not see budget deficits, and some even saw budget surpluses. Only nine states are expected to see budget gaps of 10% or greater. States most impacted by the recession were those dependent on tourism and energy production. Governments that rely on tourism spending were hard hit by reduced travel and social distancing measures. Lower demand for oil and natural gas hurt states dependent on energy tax revenue.
Most states rely heavily on income taxes, and the initial spike in unemployment in early 2020 did not bode well for state revenues. But job losses have been concentrated in low wage sectors like tourism and hospitality, mitigating the net impact on state revenues. High wage workers were able to transition to work from home and did not see the same rate of losses. Enhanced unemployment benefits have also propped up income tax collections and consumer spending, but states without income taxes like Texas and Florida still saw larger revenue declines. Overall, tax-backed credits have held up very well throughout the pandemic, benefiting from their broad flexibility to respond to revenue fluctuation.
The $195 billion in new federal aid for state governments equals an estimated 16% of own-source, FY19 state revenues. The pandemic-induced downturn is now estimated to produce a net revenue shortfall of only $56 billion for states between FY20 and FY22, equal to about 6% of FY19 state general fund revenues, making the new funding a major stimulus boost.
Half of the direct stimulus funding for states and locals will be available in the next few months, with the remainder distributed a year from now. State and local governments will have until the end of 2024 to spend stimulus aid, allowing for a more strategic and staggered deployment of funds. Funding cannot be used for pension payments or to fund tax cuts, but it may be used to replace lost revenues, meaning near-term fiscal stress should be deferred for several years for most issuers. If the economic stimulus proves effective, revenues could return to normal quickly.
Most high-profile, high-issuance states like California, New York, New Jersey and Illinois will see a positive impact.
California’s budget picture has markedly outperformed budgeted expectations. Revenues are nearly back to pre-pandemic levels and state costs were not as high as anticipated, resulting in a $15 billion budget windfall to allocate toward the FY22 budget. This is a sharp turnaround from where the state was last summer, needing to fill an estimated $54.3 billion budget shortfall. Governor Newsom’s budget proposal for FY22 is 5.5% higher than the prior year’s revised budget and continues to add to its rainy day fund. The budget doesn’t reflect the COVID-19 relief bill enacted late last year nor the $26 billion for the state from the newly enacted ARP Act, and assumes a later vaccine rollout date. Therefore, the state could be in an even stronger fiscal position.
New York’s budget picture has improved from earlier predictions. FY21 is now projected to end in balance, thanks to better-than-expected tax revenues, reductions in local aid and already received federal assistance. Reductions in local aid, originally anticipated at $8.2 billion, now look to come in around $2.9 billion. New York State is in line to receive $50 billion in aid under the American Rescue Plan Act, with $12.6 billion dedicated to state government alone. New York State recently agreed to a new $212 billion FY22 budget that increases spending approximately 9.3% over FY21 and raises its top income tax rate to 10.9% for high earners. When combined with New York City’s top rate of 3.88%, this produces a highest-in-the-nation income tax rate of 14.78% for high-income city residents.
Like many states, New Jersey’s revenues are faring better than originally projected. Due to an expected budget gap, the state issued $4.3 billion in deficit financing bonds in November 2020. Now, the state forecasts that FY21 revenues, excluding bond proceeds, will be up $3.4 billion (9.4%) compared to budget. While this is still lower than what was assumed in the governor’s proposed budget pre-pandemic, the revised projections indicate the state’s deficit borrowing was probably unnecessary. Governor Murphy’s budget proposal for FY22 increases spending by 9%, partially to make the full pension contribution for the first time in decades. New Jersey is slated to receive $6.4 billion from the ARP Act, which could eliminate the need to spend down $4 billion in reserves as proposed in the budget.
S&P and Moody’s have both revised their rating outlook for Illinois to stable from negative.
Illinois was the only state to rely on the Fed’s Municipal Liquidity Facility during the pandemic, borrowing twice last year to supplement cash flow. Recent revenue collections have out-performed budget to the extent that the state accelerated payments to pay off MLF borrowing. The proposed FY22 budget is balanced in terms of current-year obligations, but still structurally imbalanced due to pension contributions that fall far short of an actuarially-based amount.
Positively, the budget proposal does not rely on any anticipated federal aid. Illinois expects to receive $7.5 billion in new federal stimulus funding, equal to about 20% of projected FY21 revenues. There are not yet formal plans to spend this funding, but state leaders have indicated they’ll direct up to $3 billion to pay back MLF borrowing and help the state catch up on its bill backlog, which currently stands at $5.4 billion. The state remains the lowest rated at BBB-, but S&P and Moody’s have both revised their rating outlook to stable from negative as the fiscal situation has improved.
Positive momentum continues
The municipal market is enjoying many tailwinds, particularly in the realm of credit quality. Lower-rated general obligation bonds (GOs) are benefiting enormously from the stimulus, and dedicated tax bonds have held up well as the property markets continue to show strength. Leisure travel is approaching pre-pandemic levels, and airport traffic is returning. Major hospital systems have adjusted to the realities of the virus, and their operations and financials have largely returned to normal.
Given these developments, and the light at the end of the pandemic tunnel, ratings agencies have responded by increasing their outlook to stable for many holdings and sectors. For instance, Illinois bonds have been the top performing state GO, with downgrade risk postponed for at least several years. Looking forward, an infrastructure package alongside tax increases could be another tailwind. But headwinds do exist. Treasury market volatility has increased and we are still searching for that new equilibrium level. Rate volatility may be the biggest near-term risk to the municipal market. At low ratios, municipals have less cushion with which to outperform.
Will the latest round of stimulus combined with a full-blown economic reopening create inflation? Given that most investors are predicting an inflation scare this year, it becomes a bit less scary when inflation eventually ticks up. Rising inflation expectations, combined with a growing federal deficit, create pressure on Treasuries. But much of this dynamic was priced into fixed income markets in the first quarter. Interestingly, rates started to stabilize at the end of March, just as the yield increase triggered significant demand.
Looking ahead, we believe more winds are blowing positively than negatively for municipal performance.
- 2021 will be a transition year. The path to normalization will be long but ultimately successful.
- The Federal Reserve and U.S. Treasury will support the markets, benefiting municipals.
- Monetary stimulus and low rates are supporting liquidity and economic activity as conditions stabilize. Inflation will remain low as labor productivity increases.
- Treasury yields should increase moderately, but the effect on municipals should be cushioned by yield spreads and the scarcity of tax-exempt bonds.
- The importance of the underlying municipal projects typically stabilizes the credit.
- Downgrades and defaults have been lower than expected, and clarity on credit health will lift investor confidence.
- As we look to the future, the market will focus on the potential for rising tax rates, which should boost demand for municipals.
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. The State of New Jersey Budget in Brief, Fiscal Year 2022, State of Illinois Proposed FY 2022 Budget, Moody’s Analytics, Stress-Testing States: COVID-19-A Year Later February 19, 2021. California Governor’s Budget Summary 2021-2022, January 8, 2021; Legislative Analyst Office, The 2021-22 Budget: Overview of the Governor’s Budget, January 2021.
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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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