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."