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July 24, 2020 | GSAM Connect

Muni Mid-Year: Crisis Averted, Stay Vigilant

For municipal bond investors, the first half of 2020 was one for the history books: record outflows in March, followed by a big rebound in the second quarter. Despite lingering concerns about issuers’ financial health and policy rates firmly anchored at zero, we still see opportunities for investors in the second half. Here are some key themes to consider:

Credit Looks Compelling, Especially BBBs

The steep drawdown in March and concern about the financial impact of shutdowns on municipal budgets raised questions about municipal creditworthiness. They also, however, created opportunities for investors seeking extra income.

While headline risk is likely to remain elevated, we believe medium grade and high-yield municipals look more attractive than they have in years.

BBB-rated munis offer an additional 1.92% of yield when compared to AAA-rated munis, while high-yield municipal bonds offer a yield pickup of 3.76%1. Late in February, the respective credit spreads hovered around 0.70% and 2.18%. Both also offer a sizable pickup over comparably-rated corporate bonds on a tax-equivalent basis (Exhibit 1).

EXHIBIT 1: Munis Have Offered Attractive Tax-Equivalent Yields Compared to Similarly Rated Corporates

Source: Bloomberg Barclays, as of 7/17/2020. Tax Equivalent Yield (TEY) is the comparable yield a tax-free municipal fund has relative to a taxable fund, adjusting for the reduced earnings after tax on a taxable fund. TEY assumes 37% Federal Tax Rate, 3.8% Affordable Health Care Tax. BBB munis and corporates proxied by the BBB segments of the Bloomberg Barclays Municipal Bond Index and Bloomberg Barclays US Corporate Index, respectively. HY munis and corporates proxied by the Bloomberg Barclays High Yield Municipal Bond Index and the Bloomberg Barclays US Corporate High Yield Index, respectively.  Past performance does not guarantee future results, which may vary.

 

We consider BBBs one of the best values in the municipal bond market – investment-grade securities offering exposure to traditional general obligations of state and local governments.  

High-yield munis, in our view, are among the most idiosyncratic corners of the capital market and, given the uncertain economic outlook, require a more selective approach. This is especially so in sectors such as project finance, which started the year with overly optimistic growth projections and weak bondholder protections.

We believe there are still opportunities for careful investors, including in sectors such as healthcare and transportation that were hit hard by COVID-19.

Elsewhere, we think tobacco securitizations that can tolerate large declines in cigarette consumption have weakened due to overall market technical factors but may yet offer value for investors seeking extra income. Credit fundamentals have in fact been better than expected year-to-date.

Within higher education, universities with sound balance sheets and large endowments appear poised to withstand short-term demand disruptions caused by the pandemic and government shutdowns.

Focus on Intermediate Maturities

We understand why investors have sought safety by pouring cash into government money market funds, but the average government money market fund offers a meager 0.03% yield2. And with the Federal Reserve likely to keep the overnight federal funds rate near zero through 2022, we think it makes sense for investors to look for extra income from intermediate maturity bonds. 

Over the long-run, intermediate muni investors have earned positive returns 100% of the time over rolling 2-year periods and have outperformed muni cash 89% of the time (Exhibit 2).  

EXHIBIT 2: Historical Outperformance of Intermediate Duration Munis Over Muni Cash

Source: Bloomberg Barclays, as of 6/30/2020. SIFMA represents the Securities Industry and Financial Markets Association Municipal Swap Index. It is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obligations. Municipal Bond 1-10Y Index represents the Bloomberg Barclays Municipal Bond 1-10Y Blend Index. Past performance does not guarantee future results, which may vary.

 

Consider Taxable Munis

Taxable municipal issuance has surged as a result of the 2017 US Tax Cuts and Job Act that eliminated tax-exempt advance refundings for muni issuers. We expect taxable issuance in 2020 to eclipse last year’s $70 billion total, which was the highest since 2010. At the midpoint of 2020 taxable issuance reached $53 billion, or 232% higher than this time last year3.

Issuance has been broadly diversified across sectors, with several $1 billion plus deals this year, and investor demand has grown. The increase in taxable supply, meanwhile, has come at the expense of the tax-exempt municipals that investors typically crave.

Muni investors who are reluctant to invest in taxable munis may want to reconsider. We think these securities may offer attractive after-tax income, especially when high-quality tax-exempt municipal valuations become stretched.

2020 Presidential Election & Shifting Policy Winds

We think investors should focus on potential policy changes rather than try to predict who will spend the next four years in the White House, as fiscal policy and tax policy changes tend to affect municipal bond prices. A “wave” election, whether red or blue, is more likely to bring big policy changes.

If Republicans retain the White House and pick up seats in the House and hold the Senate, policies to further stimulate the economy through additional tax cuts may be on the table. This may increase uncertainty in the municipal market and affect the relative attractiveness of the asset class.

Should Democrats gain control of both chambers of Congress and the White House, we think investors should watch for changes to personal income tax rates, the corporate income tax rate and the cap to the state and local tax deduction. Higher taxes may increase the relative attractiveness of municipal bonds, though an increased cap or complete elimination of the cap on state and local tax deduction could dampen muni demand—especially in states with higher-than-average taxes.

Since none of us have a crystal ball, we think investors should plan for bumps in the road. But it’s risky to limit a portfolio to safer, lower-yielding investments, which may underperform in the second half. Our suggestion: stay vigilant, but don’t close your eyes to potential opportunities. 

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