Muni story remains a good one

What a difference a roaring recovery and unprecedented fiscal stimulus make. Moody’s municipal bond rating downgrades exceeded upgrades in 2020 for the first time since 2014, and at one point during the year, all three major rating agencies had negative credit outlooks on nearly all municipal bond sectors. Now, nearly all the negative outlooks have flipped to positive or stable, with two of the lower-rated states, Illinois and Connecticut, recently upgraded by one or more of the ratings agencies.

Three forces drove the turnabout. First, the rapid economic rebound supported by vaccination pushed actual and expected sales and income tax revenues higher, adding to their momentum after they vastly outperformed worst-case fears when the Covid-19 pandemic was in full swing. Second, residential property values are soaring with home prices, boosting tax bases for local governments that generally rely heavily on property tax revenue. And third, March’s $1.9 trillion American Rescue Plan provided massive federal funding to various municipal sectors, including state and local governments, higher education, airports, mass transit and hospitals, bolstering liquidity for many municipal borrowers. 

This rebound, and rising concerns about the potential for higher income taxes under a Democratic White House and Congress, has fueled record flows into munis this year. According to J.P. Morgan, the year-to-date inflow of $64 billion through early July would rank as the third-highest annual inflow since Lipper began tracking the data in 1992, with nearly a half year still to go. Year-to-date, the municipal bond sector has outperformed all other high-quality bond sectors, posting positive returns versus negative returns for U.S. Treasuries, investment-grade corporates, mortgages and the overall Bloomberg Barclays Aggregate Bond Index, according to Bloomberg Barclays indexes. The same holds for high-yield munis relative to high-yield corporates. And if the tax-exempt component of muni returns were included in the calculations, they would fare even better.

The road from here could prove a little bumpier. For example, the ratio of yields on the Bloomberg AAA 10-year muni to 10-year Treasury stands at about 63% versus the trailing 20-year median of 90%. So, a move higher in muni yields relative to Treasury yields wouldn’t surprise. This would be almost certain if the Biden administration fails to significantly increase top individual or corporate tax rates. On the other hand, the demand drivers of the aforementioned positive credit dynamics as well as aging investor demographics remain in place, indicating the muni-to-Treasury yield ratio that began the year somewhat rich could remain so without much drag on future demand or performance.