Taxable municipals gain from credit strength
- A flattening yield curve with declining interest rates enabled longer-maturity bonds to outperform.
- Outperformance compared to other high-quality fixed income asset classes reflects investors’ confidence in municipal credit.
- 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 in the U.S., 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.
U.S. 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 Federal Reserve 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, win passage through Congress and become law. 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 inflation 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 re-entering 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.
The taxable 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 fundamentals.
After steepening during the first quarter, the yield curve experienced a bull flattener during the second quarter as interest rates fell on tenors dated 5 years and longer. The flattening of the yield curve and declining interest rates caused longer-maturity bonds to outperform those in shorter maturity ranges.
While the movement in interest rates generally supported the municipal market, the dominant themes continued to be the performance of lower-quality bonds and the reopening trend that continues to boost sentiment across municipal credit. Similar to the previous quarter, lower-quality bonds outperformed. For example, BBB-rated and A-rated taxable municipals produced total returns of 5.38% and 4.38%, respectively.
Credit fundamentals have gained strength from three factors: 1) better than expected revenues; 2) significant fiscal stimulus directly benefitting municipal issuers; and 3) states and cities that are now fully reopened. Against this backdrop of improving fundamentals and declining U.S. Treasury yields, taxable municipal bonds outperformed U.S. corporate bonds and U.S. Treasury bonds during the quarter.
The yield curve experienced a bull flattener, as interest rates fell on tenors dated 5 years and longer.
Total municipal bond issuance, including tax-exempts, 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. In 2021, April and May issuance was up vs. the same period last year, while June was down slightly. Overall, second quarter issuance is up 5% year-over-year despite the fact that refundings are down -17.7% over the same period. Taxable municipal bond issuance is 5.4% higher year-over-year.
Demand for taxable municipals continues to be robust, as new issue deals are routinely oversubscribed and dealer inventories remain light. The resiliency of municipal credit has bolstered demand for the asset class and attractive valuations and low-cost hedging continue to support interest globally.
Credit spreads continued narrowing during the quarter. Option-adjusted spreads for the Bloomberg Barclays Taxable Municipal Index tightened by -9 bps during the quarter. Looking a bit deeper, BBB-rated bonds led the way in spread tightening, narrowing by -36 bps. A-rated and AA-rated bonds also tightened, narrowing 9 bps and 7 bps, respectively. Looking forward, the pace of credit spread tightening may slow as the highest quality issuers may be approaching full valuation; however, lower-quality bonds still may have room to tighten, and careful credit selection should continue to reward investors.
As of the end of June, there have been roughly $1.1 billion in payment defaults across the entire $3.7 trillion asset class. Taxable municipals, a subset of the broader universe, witnessed no defaults over this same time period. We note that the $1.1 billion in defaults across the entire asset class represents just 0.03% and compares favorably to the 2.5% default rate witnessed in the corporate sector.
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 Act 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 two 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 and other lower-rated names.
Implications of infrastructure spending
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.
The current proposal funds surface transportation (road, bridges and 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.
Many plan details have yet to be fleshed out, including a number of possible measures that could directly affect the municipal bond market. 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.
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 has been very resilient, outperforming most 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 Act 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.
Overall credit is improving
Tighter credit spreads 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.
Taxable municipals have shown strong first-half performance, amid spread compression and enhanced income levels. Lowered expectations for further spread tightening could mean income becomes the primary source of returns. This is not necessarily a negative for investors. Credit selection and access to idiosyncratic opportunities remain key.
A potential infrastructure package could be market moving. Key issues and questions for municipals include the potential return of Build America Bonds, tax-exempt advance refundings 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 and Bank of America/Merrill Lynch High Yield Credit Chartbook. 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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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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