Though low yields and rising inflation are turning some investors away from fixed income, 2021 is shaping up to be a potentially strong year for municipal bonds.

Long seen as a sleepier, even boring side of fixed-income markets, the municipal bond space is heating up, thanks in part to the ambitious tax proposals being put forth, said Jeff Timlin, head of municipal bond investing at Sage Advisory.

“Once Biden got elected, we knew that the talk of higher tax rates—obviously, higher federal taxes, but higher taxes across the board with both individuals and corporations—would be a positive for municipal bonds from a demand standpoint,” said Timlin. “With higher yields creeping in slowly, the desire for income and tax-free income in particular is going to be more attractive despite some of the price losses bond investors have seen.”

But there are other reasons the municipal market is looking stronger in 2021—one being the massive $1.9 trillion stimulus package passed and signed in early March. That bill provided $500 billion in direct aid for state and local governments, which Timlin said helps to solidify municipals from a credit perspective.

While prior Covid-19 relief bills did not provide such a large injection of aid to governments, Timlin argued that the need didn’t exist.

“When we look at the two stimulus deals that came last year, we still ended up having a budget deficit across all 50 states and local governments totaling an additional $7.6 billion relative to 2019,” said Timlin. “In the long run, that looks like more of a rounding error or normal, minor slowdown. Thus, the most recent deal is what we would consider stimulus rather than budgetary support.”

Also adding to the strength of the municipals market is the potential for infrastructure spending, said Timlin. President Joe Biden addressed both houses of Congress on Wednesday in part to lobby for $2.2 trillion in infrastructure spending, taking an expansive view on the definition of infrastructure.

The areas of infrastructure most additive to the strength of the municipal bond market, according to Timlin, are the ones focued on transportation spending.

“In our opinion, this is more of a low probability event over the next year or two as the administration deals with the effects of Covid-19,” said Timlin.

Without Taxes And Stimulus
Municipals might be gaining in attractiveness even without a boost from policy makers, said Timlin.

For one thing, liquidity in the municipal market has improved with more bidders seeking issuances in blocks of one million bonds or less.

“Historically, anything that has traded in sub-million bond blocks has experienced a larger bid-ask spread, but today there’s a tremendous amount of demand among retail traders for sub-million paper and sub-hundred-thousand paper that rarely got attention previously,” Timlin said.

The increase in liquidity is also being driven by broker-dealers engaging in algorithmic trading. Over time, this creates more competitive bids on municipal bonds, improving liquidity in the market, but it will also lower the liquidity premium in certain municipal issues, leading to lower yields over time.

“In terms of defaults, it’s amazing to look at municipals,” said Timlin. “I always get questions about defaults in muni land, and it’s not to say that it never happens, but it’s incredibly rare.”

That’s because state and local governments can exercise taxation authority to help pay down their debts, said Timlin. Still, some defaults have occurred. In 2016, Puerto Rico defaulted on municipal debt, and before that the city of Detroit defaulted on its general allocation bonds.

Downgrades have been significantly more commonplace, said Timlin, but not out of line for what should happen in a near total economic shutdown in the early weeks of the pandemic.

“We did see some defaults pick up, but not in traditional areas of the market,” he said. “These were concentrated in senior living facilities and small healthcare providers as well as some esoteric or one-off issuers. When you shut down revenue sources, bad things can happen, but those bonds were held by relatively few people, institutions and funds. The downturn didn’t hit overall performance of a diversified municipal bond portfolio too badly.”

Municipal bonds have also outperformed because they tend to have lower beta relative to Treasury bond yields, in part because continuing strong demand for municipal bonds has supported the market.

There has also been a gradual reduction in the supply of tax-exempt bonds over the past decade that wasn’t knocked off-kilter by 2020’s volatility. Out of $480 billion of municipal issuance in 2020, only two-thirds of that total was tax-exempt, with only $300 billion in tax-exempt new issues coming to market for the year.

Timlin guessed that aggressive tax policies proposed by the White House and congressional Democrats might lead some high-net-worth investors to shift away from equities and other securities impacted by potential changes to capital gains, income and estate taxes.

Even with President Joseph Biden’s promise to only raise taxes on those making over $400,000 per year—a small market, according to Timlin—the amount of purchasing dollars potentially seeking solutions in municipal bonds is “significant” compared to the supply available.

“For the remainder of 2021, the areas that will perform well are likely the areas that have to this point been laggards,” said Timlin. “Higher education paper from colleges and universities, particularly smaller or mid-tier institutions. The larger and well-known institutions have already ratcheted down the spread levels they were at before. In smaller institutions, the spreads still need to compress, and when they do, they will outperform the market.

Transportation is another area that will rebound, said Timlin. For the last year, toll roads and gas-tax receipts have been down. But airports “have recovered better than I thought,” he said, and their securities are difficult to source because “nobody’s trading.”

“Most of the easy money has been made, but we might also see come recovery in areas supported by dedicated tax streams—income taxes, sales taxes, excise taxes and other special types of taxes. Receipts will recover to pre-Covid levels."