- Our Blog
Stronger fundamentals, undervalued segments and an improving economic outlook point to renewed potential for municipal bonds in 2021.
After suffering the largest selloff in their history last March, municipal bonds have seen a strong recovery off lows, and we believe that there’s room for munis to move even higher in 2021. Multiple catalysts fuel our optimism, including the probability of higher taxes, the likelihood of renewed fiscal stimulus and the potential for continued credit spread tightening as the recovery unfolds. We believe these significant demand drivers, alongside portions of the market remaining undervalued, are creating a positive backdrop for municipal investors.
A muni bond win-win
When we analyzed potential impacts of the 2020 elections last fall, all of the possible outcomes created at least some degree of benefit for tax-exempt investors. However, unified Democratic control of Congress and the White House was the most positive of those scenarios, and with that outcome now a reality, we will very likely see a push toward higher federal tax rates for both individuals and corporations.
When the Tax Cuts and Jobs Act (TCJA) reduced corporate rates from 35% to 21%, an important segment of investors — namely banks and insurance companies — effectively left the tax-exempt muni market. For this group, an increase in the corporate tax rate could provide enough of an incentive to make tax-free muni bonds attractive again. This increase in demand, coupled with higher taxes on high-net-worth individuals, should improve support for municipal bond prices overall and reinforce the positive technical environment.
While higher tax rates may jumpstart demand and lift prices, more generous fiscal stimulus could provide the catalyst for underlying credit improvement. The initial rounds of stimulus provided much needed support to areas of the economy first battered by COVID. From hospitals to transportation, small businesses and consumers, much of the relief was a lifeline to essential portions of the economy. State and local governments, however, were excluded from the initial rounds of stimulus.
Despite this exclusion, most states haven’t experienced the shortfalls they initially expected. The uniqueness of the COVID recession helped them avoid worse outcomes: job losses were centered in low-wage sectors, which left personal income tax collections from higher wage earners largely intact. Property tax collections also held steady on the strength of the residential housing market and the sharp rebound in equity market values created a capital gains windfall.
Targeted aid for municipalities is a core part of the Democratic relief plan, and with nearly complete control of the legislative and policy levers, there is a high likelihood that direct federal aid for municipalities will be part of the next stimulus package. Federal revenue support could help cover gaps in 2021 fiscal year budgets (ending June 30), allowing states to conserve funds and hold their ground as they wait for the economy to rebound to pre-COVID levels, mitigating broad concerns around municipal credit fundamentals.
Finding the sweet spots
Investors looking for bargains might dismiss the opportunity in munis if they focus solely on the higher quality portions of the market. To date, the highest quality segment of the municipal market has rebounded more fully, leaving AAA-rated bonds rich by most valuation measures. While higher taxes and/or direct fiscal support to state governments has the potential to increase demand for high-quality paper, investors may be better served pursuing total return opportunities in lower rated bonds. We think uneven ratings across sectors and continuing borrower uncertainty will create opportunities for individual security selection to drive returns. Some uncertainty is likely to remain in a still uneven recovery, but gradual progress toward a post-COVID normal should continue to drive spread compression between higher and lower rated municipal bond segments. It is unlikely that recovery progression will be completely one-directional, so we view any temporary weakness as a buying opportunity underpinned by our solid long-term outlook for the sector.
The bottom line: Stay smart and flexible
Market dislocations like last year’s historic muni selloff often create compelling investment opportunities. For munis in 2021, this means favoring the sharp pencil over the broad brush, staying flexible in your investment implementation and being selective and disciplined in choosing individual bonds.