Retail demand for U.S. municipal bonds continued to surge in the third quarter, following a solid first half. The credit backdrop has vastly improved – and with it, retail demand – aided by the U.S. Federal Reserve’s (Fed) broad array of actions to support the economy, including direct help for state and local governments. Expectations for higher U.S. tax rates in 2022 are also adding to investor confidence. Consequently, U.S. municipal bonds have performed better than expected, and we believe demand will remain strong into 2022. Much of the good news, however, is already baked into valuations, with high quality U.S. municipals featuring generationally low yields and rich valuations relative to taxable U.S. corporates and U.S. Treasuries.
Credit conditions on the mend but recovery has been uneven
Robust monetary and fiscal support has led to a faster-than-expected recovery from the COVID-19 pandemic for many states and local governments, and the credit cycle has largely turned positive.
Among the indicators of improved credit conditions:
- U.S. Municipal credit rating upgrades have outpaced downgrades throughout much of the year.Footnotei
- California – the largest issuer of municipal bonds – has turned a $54 billion shortfall for fiscal year 2021 into a $76 billion budget surplus for fiscal year 2022.
- Following record-setting tax collections in March and April, New Jersey’s revenues are projected to hit all-time highs in fiscal year 2022, with the state now projecting a $10 billion budget surplus for the year – a nearly $4 billion improvement from February estimates.
- Illinois received two of its first bond rating upgrades in 25 years.
- House price appreciation is supporting local credit that depends primarily on property tax collections.Footnoteii
Still, the recovery has been uneven. In the same way that the pandemic disproportionately affected low-income earners, not all states and local governments are experiencing the same levels of resurgence. Pandemic-fueled risks remain, and what could be broadly viewed as a recovery trade has not been all-encompassing.
In particular, large cities hit hard by earlier lockdown orders and outmigration are seeing their comeback efforts scuttled as the COVID-19 Delta variant delays return-to-office plans. Notably, the city of Chicago is already projecting a $733 million budget gap for fiscal year 2022. In addition, we are seeing secular headwinds to more vulnerable sectors, such as senior living facilities, along with flagging sales tax collections for some U.S. retailers.
Public policy centered on infrastructure supportive of munis
The $1 trillion infrastructure bill currently being considered by the House includes major investments in traditional infrastructure, such as roads, bridges, rail, water utilities, and energy transmission, as well as projects to combat climate change and expand broadband internet access. We anticipate this legislation will broadly support muni credit in the coming years. Airports with large capital plans, and water and sewer systems with aging infrastructure that need to comply with environmental requirements, are likely to see their credit ratings improve.
Oversupply concerns have been assuaged for now; the bill currently being considered does not address advance refunding bonds,Footnoteiii> which lost their tax-exempt status with the passage of the 2017 Tax Cuts and Jobs Act (TCJA). Reinstatement of a taxable subsidy bond, similar to Build America Bonds (BABs), was included in draft legislation but ultimately excluded from the final bill. Both BABs and advance refundings may resurface as part of the larger reconciliation bill. However, an immediate supply surge appears unlikely.
Instead, we see a more balanced level of supply over the medium term, with digestible increases in issuance a welcome counter to the record demand in 2021. The infrastructure bill allocates $550 billion to support municipal infrastructure projects, a force that could potentially spur a wave of new financings and end the decade-long trend of net negative supply. It also increased the allowed annual allocation to Private Activity Bonds from $15 billion to $30 billion, which should open up more opportunities to invest in Public Private Partnerships (P3s), and other project finance deals that often carry a complexity premium. Given the long lead time for new projects, this is likely a story for 2022 and beyond.
High quality tax-exempt valuations are stretched
Improved credit conditions and continued strong demand have resulted in record low yields and rich valuations for the highest-quality U.S. munis, relative to U.S. corporates and U.S. Treasuries. Ten-year AAA benchmark tax-exempt yields are trading at 75% of 10-year Treasuries, well below the 10-year average of 90% to 95% (see Figure 1).
But not all the gains have been at the highest end of the credit spectrum. In 2020, US high yield bonds lagged their investment grade counterparts by a wide margin. Since then, yield-seeking investors have funneled assets into U.S. high yield munis, narrowing spreads to fair value and turning high yield municipals into year-to-date market leaders. As of 30 September, the yield-to-worst on the muni high yield index was 4.0% but still provides 120 basis points of additional yield versus high yield corporates when adjusted for taxesFootnoteiv (see Figure 2). High yield municipal default rates remain a fraction of global corporates, defaulting about 23% as frequently.Footnotev
Within muni allocations, we believe now is a good time to improve portfolio flexibility. Liquidity remains challenged, as dealer inventories have shrunk relative to total municipal fund assets. In fact, dealer inventories now represent less than 1% of total mutual fund and ETF assets, down from more than 15% in 2008.Footnotevi Thus, relatively small fund outflows from retail investors can disrupt the market. Favorable market conditions today provide an excellent time to prepare for future bouts of volatility that may arise from a structural decline in muni market liquidity.
Puerto Rican debt presents opportunities
Puerto Rico continues to make progress in its quest to exit Title III bankruptcy, which it declared in 2017 amid crushing debt loads, a contracting economy, and a population exodus. The Commonwealth entered Title III with over $120 billion of outstanding debt and pension liabilities. Its financial challenges were compounded by two hurricanes in 2017 and a series of earthquakes in December 2019 and January 2020, which caused more than $80 billion and $200 million in damage, respectively.
Yet despite the challenges, we see compelling reasons to reconsider an investment in Puerto Rico debt. By deferring debt service during the bankruptcy proceedings, the Commonwealth had amassed a substantial $11.8 billion cash position in the Treasury single account as of 30 July 2021. General fund revenues in fiscal 2021 (ended June 30) rebounded from COVID-19-induced lows in 2020, jumping 26% to $11.7 billion.Footnotevii In addition, the island continues to receive substantial support from the U.S. federal government. Over $80 billion of disaster relief funding is expected from federal and private insurance to aid reconstruction and to subsidize tax collections for the next 18 years.
The Commonwealth is also making substantial progress in restructuring its high debt burden. The oversight board successfully reorganized the debt issued by the Puerto Sales Tax Finance Corp. (COFINA). COFINA, which had $17 billion of senior and subordinate sales-tax-backed bonds outstanding, exited Title III in February 2019 with a 30% debt reduction.
The oversight board has also filed a Plan of Adjustment (POA) with the Title III court that would cut its $35 billion of outstanding debt, including Puerto Rico general obligation bonds, by approximately 80%. The POA has broad support from various creditors’ committees, including a large group of unsecured creditors, increasing the probability the Title III court will approve it. There remains execution risk to the POA, as it includes a modest reduction to some pension benefits, though approximately 72% of retirees would be untouched. The Commonwealth’s governor and legislators are reluctant to agree to any measure that would cut pensions, and their holdout could impede the issuance of new debt instruments. Ultimately, we believe the oversight board will find a solution to the impasse and the POA will be confirmed by the Title III court later this year or early in the first quarter of 2022.
In our view, Puerto Rico debt is compelling as the reorganization process moves toward completion. Municipal bonds of entities emerging from a bankruptcy reorganization have typically outperformed over time. Often, reorganized issuers receive clarity in the bankruptcy process over any prior legal ambiguities centered on their liens, or cede future questions over the legal rights of creditors and contests to the bankruptcy court that confirmed the plans of adjustment. In addition, we believe there will be substantial demand from municipal high yield investors. Many Puerto Rico issuers will remain below investment grade when they emerge and therefore will be included in the Bloomberg Municipal HY Index. Indeed, we estimate that Puerto Rico may compose up to 18% of the index when all Title III cases are resolved. [See Figure 3 for two examples.)
Taxables’ appeal holds
Following a record year of supply in 2020, taxable municipal new issuance remains robust in 2021 with over $81.8 billion issued as of 30 September.Footnoteviii The total market size is now approaching $750 billion. Notably, we have seen many first-time issuers of taxable municipals participating in the marketplace – low interest rates and the inability of issuers to advance refund outstanding tax-exempt debt with new tax-exempt issues have proven a potent combination. Although the potential restoration of tax-exempt advance refunding remains a key risk to taxable supply, the Bipartisan Infrastructure Framework maintains the status quo for now.
U.S. taxable municipals have enjoyed strong performance in 2021. The broad Bloomberg Taxable Municipal Index returned 0.50% year-to-date as of 30 September, while the Bloomberg US Corporate Index lost 1.27% and the Bloomberg US Treasury Index lost 2.50%. Outperformance was driven by tightening credit spreads, amid a robust recovery in state and local government revenues.
We are seeing renewed interest from domestic and overseas long duration-oriented investors, using the recent supply surge to increase allocations. The majority of taxable municipals are long dated and high quality, with over 50% of the taxable municipal indexFootnoteix maintaining a rating of AA- or higher. Lower cross-currency hedging costs for overseas investors, and declining correlations to corporate investment grade (IG) indices, may continue to provide a demand tailwind as new allocations to the asset class grow.
On balance, we believe the outlook for U.S. munis remains constructive as we ease through a period of peak economic growth and policy support. We believe economic growth will moderate in 2022, but remain above historical trends. In the meantime, we think inflation will be transitory and fade when supply chains normalize and the U.S. Fed begins tightening monetary policy.
For investors concerned about macro risks, we believe U.S. municipals remain a compelling defensive option. U.S. Munis have historically outperformed during periods of rising rates, have lower default rates than corporates, and have lower correlations to risk assets should the economy stumble.Footnotex
Given current valuations, we are underweight high quality duration in favor of select securities farther down the risk spectrum. We also favor building flexibility into muni allocations, as liquidity should enable investors to take advantage of future dislocations. Agility will be especially important should we see a reversal in the huge fund inflows witnessed over the last 12 months.
For opportunistic municipal investors, Puerto Rico also represents an outsize opportunity to capture potential yield as the territory emerges from bankruptcy. Infrastructure policy, too, should serve as a market catalyst that could provide new supply and investment opportunities.