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May 24, 2021 | GSAM Connect

Municipal Bonds: Why It's Important to be Flexible

Fiscal stimulus, an aggressive infrastructure plan and the possibility of higher taxes to pay for it have sparked a surge in municipal bond demand. But even at current prices, we still see value in the sector for active investors.

Considering the circumstances, it isn’t surprising to see municipals trading at the expensive end of their historical range. Because they’re tied to growth-sensitive tax revenues, munis often outperform when the US outlook improves and interest rates rise, as they did in the first quarter of 2021.

Meanwhile, the $350 billion American Rescue Plan is likely to shore up state and local finances while anticipated tax hikes tied to US President Joe Biden’s proposed infrastructure plan are increasing investor demand for tax-exempt bonds.

But we think municipal bonds can stay expensive for longer than investors may realize, provided technical and fundamental factors remain supportive. For example, we expect to see $137 billion in redemptions between June and August (calls, maturities and coupon payments), in line with the four-year average1. That amounts to money that would have to be reinvested into the market, further supporting prices.

Finding the best value in these conditions can be challenging and, in our view, calls for an active and flexible approach to the municipal bond market. To us, this means that investors should focus on three things:

  1. Look Beyond High-Grade Bonds:  Medium-grade and lower-rated municipal bonds offer a significant yield pick up over high-grade bonds that is attractive on an absolute and tax equivalent basis. Many have won upgrades from ratings agencies since the passage of the American Rescue plan. Yet credit spreads are still wider than they were before the pandemic, which adds up to better return potential. As the US economy strengthens, more economically sensitive municipal credit may be well positioned to outperform. 
  2. Curve Positioning Matters: Short-term municipals are historically among the most stable municipal securities, but low yields will likely keep a lid on return potential. With the Federal Reserve holding front-end rates near zero, we see more value in intermediate-term bonds, which benefit from additional roll down due to a steeper yield curve. There is potential for volatility in longer-term rates as we move through the recovery, and we believe higher rates and steeper yield curves offer attractive opportunities.
  3. Stay Flexible: Venturing further out on the credit spectrum, evaluating the after-tax potential of taxable municipals or adjusting yield curve positioning requires a flexible investment approach. The more agile the investor, the better chance she has of navigating the twists and turns that come with changing market and macroeconomic conditions. In today’s environment, we think this increases the ability to earn an attractive after-tax total return.

Everyone likes a bargain. But it’s worth noting that municipal bonds held their value better than other areas of the fixed income market, including Investment Grade Corporate debt and US Treasuries, when interest rates jumped in the first quarter. Even at current valuations, we think there’s a lot to like about municipals, particularly for investors who can embrace a flexible approach.

 

1. Source: Siebert. As of 4/30/2021.

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ABOUT THE AUTHOR

Scott Diamond

Scott Diamond

Co-head of Municipal Fixed Income, Goldman Sachs Asset Management
Matthew Wrzesniewsky

Matthew Wrzesniewsky

Fixed Income Strategist, Goldman Sachs Asset Management

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