Municipal Fixed Income

Beware the ides of March

As Q1 2021 draws to a close, investors should be mindful of the seasonal weakness typically seen with municipal bonds at this time of year.
March 2021

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What’s new in munis?

As the first quarter draws to a close, investors should be mindful of the seasonal weakness typically seen with municipal bonds (munis) at this time of year. This seasonality is due to a confluence of factors, including an uptick in supply (versus a lack of), fewer maturing bonds and lower coupon payments – and a potential pause in industry flows as a result of investors paying their tax bills in April.

Historic muni seasonality

Month 1990-2020 average returns 2021 (through February)

January

0.88%

0.64%

February

0.46%

-1.63%

March

-0.21%

To be determined

April

0.44

To be determined

May

0.89%

To be determined

June

0.18%

To be determined

July

0.84%

To be determined

August

0.67%

To be determined

September

0.43%

To be determined

October

0.02%

To be determined

November

0.29%

To be determined

December

0.70%

To be determined

This chart depicts Bloomberg Barclays Municipal Bond Index monthly average returns as of February 26, 2021. Source: Investortools/Bloomberg. Past performance is not necessarily a guide to future performance.

We’re also starting to see tax-exempt munis respond to the steepening of the US Treasuries (UST) yield curve for the first time all year, an important factor to watch over the next month given that there is still room to move higher. We foresaw this possibility last year, which is one reason why after maintaining a slightly longer duration for the better part of two years, we decided to move to a neutral stance in the fourth quarter to help reduce interest rate risk. Muni/UST ratios, while off all-time lows, remain richer than historical averages.

Where we see value now

Seasonal performance aside, there are pockets of muni value as investment grade spreads still remain elevated compared to pre-pandemic averages, particularly for A and BBB-rated bonds.

Where are these pockets? We would argue that the sectors most negatively impacted by the waves of lockdowns, such as hospitals, toll roads and airports, offer the best income advantage versus the Bloomberg Barclays 1-15 Year Muni blend Index, as spreads should continue to narrow in a slowly improving economy.

Hospitals

Hospitals surprisingly fared much better than we would have anticipated heading into the pandemic last March when elective procedures (which typically have much higher margins and reimbursement rates) were prohibited in many regions across the country. The CARES Act, once introduced, allowed hospitals to bridge the elective gap and strengthen their financials. Now that elective procedures have resumed in nearly every U.S. state, we anticipate spreads for these credits will likely tighten through 2021.

U.S. hospitals buoyed by CARES funding

Chart showing that U.S. hospitals were being buoyed by the CARES act

Source: KaufmanHall, National Flash Report, January 2021.

Looking forward

The U.S. has already spent more than $4 trillion on Coronavirus relief as a whole, which is one of the reasons why we’re seeing Treasury rates move higher, along with inflation expectations running north of 2% (which the Fed appears comfortable with). Both Fed Chair Jerome Powell and Treasury Secretary Janet Yellen have reported that the U.S. unemployment rate is closer to 10% when factoring in those that have left the workforce, meaning the central bank will likely remain accommodative even if inflation surprises to the upside.

As a result, we sold some of our higher investment grade AAA and AA credits in the process of neutralizing duration back in Q4, because if we do experience a further back-up in rates, these bonds will likely see negative returns for the year. Meanwhile, we remain overweight A and BBB-rated bonds versus our benchmark, which we believe will outperform higher quality credits and serve investors better over the course of 2021.

As the economy continues to recover, we expect strong U.S. GDP growth in the first quarter, which is another reason the Fed is likely to let inflation run a little bit hot. Within our portfolio, we have neutralized duration and allowed liquidity to build slightly on the front end of the yield curve awaiting better opportunities to invest cash in the spring – when we anticipate primary issuance to increase and place upward pressure on spreads.

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Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. All of these factors can subject a fixed income portfolio to increased loss of principal.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a fixed income portfolio.

Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk.

Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.

Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is generally not subject to federal income tax but may be subject to AMT, state or local taxes.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The Bloomberg Barclays U.S. Municipal Bond 1-15 Year Blend Index is an unmanaged index of long-term tax-exempt bonds rated BAA or better with 1-17 years to maturity. Investments cannot be made in an index.

Views and opinions have been arrived at by BMO Global Asset Management. The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

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