The dire outlook for municipal bonds that was initially forecast when the economy came screeching to a halt in March never fully materialized. In fact, there have only been 13 more defaults so far in 2020 than in all of 2019, with the vast majority of the defaults occurring among munis that were initially non-rated or below investment grade to begin with.1
When the COVID-19 crisis initially began, the normally calm municipal bond market was rapidly thrust into the spotlight. Economic activity screeched to a halt, revenues plunged, and prices on many existing municipal bonds fell. To the relief of many, we don’t expect 2021 will be a repeat of 2020.
We expect the muni market to return to a sense of normalcy in 2021. However, it will continue to face headwinds due to COVID-19 and its impact on economic activity. Going forward, we suggest investors stay up in credit quality by focusing the bulk of their portfolio on issuers rated AA/Aa and above, with some exposure to A/A rated issuers depending on their risk tolerance. We see the potential for 10-year Treasury to rise to the 1.0% and 1.6% range with yields on highly rated municipal bonds likely increasing, as well.
So long 2020. Don’t let the door hit you on the way out
Although the dire outlook that was originally predicted never materialized, that’s not to say that many issuers didn’t experience financial pressures. It’s just that there was a split between the “haves” and the “have-nots,” which is a story that we expect to continue in 2021. Issuers with greater financial flexibility and revenue sources that are less tied to economic activity—factors that often translate to a higher credit rating—were generally better able to handle the drops in revenue, increases in expenses, and slowdowns in economic activity in 2020. This also translated to higher-rated issuers experiencing less volatility and outperforming their lower-rated counterparts year to date.
Higher-rated munis have outperformed in 2020
Source: Bloomberg Barclays Municipal AAA, AA, A, and Baa Total Return Indices, as of 11/24/2020. Past performance is no guarantee of future results.
What to expect for 2021
We expect the economy to gradually improve in 2021, which is supportive for the finances of most municipal bond issuers. However, the wild card is COVID-19. Further spread of the coronavirus would likely slow economic activity and affect revenues for some issuers. While news of the development of effective vaccines is positive, achieving a level of public immunization that would allow mobility to return to normal is likely to take time. Issuers that are more reliant on revenues tied to economic activity, mobility, or large gatherings—such as transportation issuers—are likely to face greater financial pressures going forward. On the other hand, issuers with more-stable revenue sources—such as a broad tax pledge—should fare better.
Although municipal bonds face headwinds in 2021, we think they are attractive relative to alternatives. As illustrated in the chart below, after-tax yields for municipal bonds are higher than both Treasuries and corporate bonds for investors in higher tax brackets.
Yields for munis are higher than corporates and Treasuries at higher tax brackets
Source: Bloomberg Barclays Municipal Bond, Corporate Bond, and Treasury Bond Indices, as of 11/24/2020. Corporate bonds assume an additional 5% state income tax. Both corporate and Treasury bonds assume an additional 3.8% ACA tax for the 32% and above tax brackets. Past performance is no guarantee of future results.
Downgrades could accelerate in 2021
We don’t expect broad defaults, but we do expect downgrades in 2021. So far, downgrades largely haven’t increased notably yet, as illustrated in the chart below, but that’s not surprising to us. Credit quality in the muni market tends to lag the economy. For example, there were few downgrades in 2007 or 2008, during the global financial crisis. However, they did occur in the subsequent years, which is a pattern that we expect to continue going forward.
Downgrades largely haven’t increased yet, but may begin to pick up
Source: Moody’s Investors Service, as of 11/2/2020
Strategies for 2021
- Keep duration below benchmark for now.As mentioned earlier, we expect longer-term interest rates to rise modestly in 2021. Although rising rates on the surface may sound like a negative for fixed income investments (yields and prices move opposite one another, all things equal), we view higher interest rates as an opportunity. A well-positioned portfolio that contains some short-term and some longer-term munis should benefit from rates moving higher.
If investing in individual bonds, consider a ladder or a barbell strategy. A ladder strategy invests equal amounts in equally spaced maturities, whereas a barbell strategy invests a portion in short-term munis and the other portion in longer-term munis. Both potentially can benefit from the flexibility of holding some short-term bonds while also locking in higher yields with longer-term bonds.
- Add credit risk in moderation.Although we favor investing the bulk of a muni portfolio in AA/Aa and above-rated issuers, a small allocation to lower-rated investment-grade issuers can be appropriate. However, we don’t suggest too large an allocation, because the additional yield that lower-rated (A/A and BBB/Baa) munis offer above an AAA-ratedindex, known as a spread, isn’t at an attractive level given the risks, in our view. As illustrated in the chart below, spreads for lower-rated munis have been falling, even though those issuers face uncertainty going forward. Spreads are likely being held down by a supply/demand imbalance and because investors are reaching for yields in the lower-rated part of the market due to low absolute yields.
Muni spreads are off their pre-pandemic highs and below their longer-term averages
Source: Bloomberg Barclays Indices, as of 11/24/2020. Basis points (BPS) represent one-hundredth of one percent; for example, 150 basis points equals 1.50%. Past performance is no guarantee of future results.
- Consider taxable munis if you’re in a lower tax bracket or investing in a tax-advantaged account.Most municipal bonds pay interest income that is exempt from federal income taxes, and potentially from state income taxes. However, some bonds pay interest income that is subject to both federal and state income taxes, and are known as taxable municipal bonds. We believe taxable municipal bonds can present an opportunity in 2021, because they may be a way to get higher yields without taking on additional credit risk. As illustrated in the chart below, taxable munis offer higher after-tax yields relative to corporate bonds at lower tax brackets. For investors in higher tax brackets, tax-exempt munis are likely to yield more on an after-tax basis.
Taxable munis are an area of opportunity, because they may yield more than alternatives after taxes
Source: Bloomberg, as of 11/24/2020. Yield-to-worst (YTW) is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. Corporate bonds and taxable municipal bonds assume a 5% state income tax for all brackets and a 3.8% ACA tax for the 32% and above tax brackets. Past performance is no guarantee of future results.
In addition to potentially higher yields, the taxable muni market is higher in credit quality, on average, relative to the corporate market. For example, 78% of the taxable muni market is AA or above, compared with only 7% of the corporate market.
However, there are risks to taxable munis. The taxable muni market is a much smaller market, so finding individual bonds or funds that invest in taxable munis can be difficult. Also, liquidity—or the ability to sell your bond in a reasonable time at a price close to what you expect—may be difficult due to the size of the market.
- Don’t treat all sectors and issuers the same. The size of the muni market is more than $3.7 trillion, with many different issuers. Below, we’ll go through some of the larger sectors and what we expect in 2021.
- State governments: Defaults are unlikely, but the sector may experience further downgrades. States that were especially hard hit by the virus or were already lower-rated to begin with are most at risk for further downgrades. The sector as a whole should be moderately stable due to the many levers that states have at their disposal to help balance their budgets. However, it is possible that a state’s credit rating could drop to below-investment-grade in 2021, which may create market volatility.
- Local governments: Most local governments rely on property taxes as their main source of revenue. So far, real estate has held up well in part due to the Federal Reserve keeping interest rates low. For example, nationally, property values have increased 5% since the start of the pandemic.2 We’re more cautious on local governments that rely on sales tax revenues—rather than property taxes—as their primary source of revenue, and already have strained finances.
- Health care: We suggest caution on the health-care sector overall. Health-care and hospital facilities were especially hit hard by the COVID-19 crisis, as it resulted in higher labor and equipment expenses and declines in revenues, partly due to suspending elective surgeries. Elective surgeries tend to be profitable for health-care providers. However, direct federal aid is helping to offset some of the negative financial impacts of the crisis. This sector could be further negatively affected if an additional round of federal aid doesn’t materialize, or the recent surge in COVID-19 cases results in postponing elective surgeries.
- Transportation (airports, toll roads, and mass-transit systems): There are opportunities in the transportation sector, but also risks. The opportunities are with issuers that do not have a high reliance on revenues generated by the system. For example, some mass-transit issuers’ bonds are backed by sales taxes or a general obligation pledge from a sponsoring city that the system serves.
On average, liquidity is also generally strong among transportation issuers, but it varies. This is another important factor for this sector in determining an issuer’s ability to manage through the crisis. We suggest caution on transportation issuers that are small and regional, are newly established, have low liquidity sources, or have a combination of those factors.
- Higher education: The higher-education sector essentially can be split into private and public colleges and universities. We think higher-rated public schools can present an opportunity, but are cautious toward lower-rated private institutions. Private colleges tend to be heavily dependent on tuition revenue, whereas public schools are less so because they receive state aid. We think there are opportunities in this sector, but there are many questions regarding what the future of higher education will look like in a post-COVID world.
- Essential services (water and sewer and electric power): We expect little to no impact on essential-services issuers. We think these types of bonds should continue to exhibit stable credit characteristics.
- Special tax: Special-tax bonds are often backed by a specific tax, such as a sales tax or a tax on hotel occupancy. They can range from being a very narrow to broad pledge. We would suggest caution on bonds backed by tourism-related taxes in this sector. Bonds backed by broad-based pledges should generally fare better.
Risks to our view
The biggest risk to our view is the coronavirus. Further spread of the virus has the potential to slow economic activity which would negatively affect some issuers. In addition to the virus, Congress failing to pass an adequate relief package in a timely fashion is another risk. The first relief package, the CARES Act, provided direct financial aid to many municipal issuers, as well as relief programs to individuals. This helped to shore up the finances of many issuers and was supportive of the economy. Without additional aid, state and local governments are likely to make further cuts to employment or services, which could weigh on economic growth.
Summing it all up
For many, including the muni market, the good news is that 2020 will soon be in the rearview mirror. Although it’s been a tough year for many, the outlook for the muni market is rosier, but it’s still not an “all clear” signal. We expect most municipal issuers will be able to manage through the adversity posed by the virus. Investors should focus the core of their portfolio on highly rated issuers and target a slightly below-benchmark duration.
1 Source: Municipal Market Analytics, as of 11/18/2020
2 Source: % change in the S&P Core-Logic Case-Shiller U.S. National Home Price NSA Index from 2/29/2020 to 8/31/2020
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