Post-election blues? Not for muni investors!

The U.S. election appears to have left us with a divided government, with the Democrats and Joe Biden retaking the White House and Republicans possibly maintaining control of the Senate pending the outcome of runoff elections in Georgia on January 5th. Democrats have maintained control of the House, albeit with a smaller margin than prior to the election. Approximately 10 seats flipped to Republicans despite Biden’s win at the top of the ticket (a couple of House races remain too close to call). Voters participated in record numbers, with over 80 million ballots cast for President-elect Biden.

The markets greeted the prospects of a divided government with a risk-on rally in the month of November, with the S&P 500® up nearly 11%. Municipal bonds posted their highest returns since August 2020 with the Bloomberg Barclays Muni Bond Index up 1.51% despite lingering economic concerns around COVID-19.

Election implications

The U.S. Senate is currently split 50-48, with the two runoff elections in Georgia to determine the fate of Senate control set for January 5. While Republicans currently hold both seats (Kelly Loeffler and David Perdue), they face strong challenges from Raphael Warnock and Jon Ossof, respectively, to retain these seats; especially with Democrats winning the state at the top of the ticket for the first time since Bill Clinton in 1992. If the Senate remains in Republican hands, it is likely the lower individual and corporate tax rates enacted under the Tax Cuts and Jobs Act (TCJA) in late 2017 will remain in place. If the Senate flips, provisions of the TCJA are likely to be rolled back, as President-elect Biden promised to repeal the TCJA’s lower corporate and personal income tax rates during the campaign. Higher income tax rates would likely make the tax exemption on municipal bond income more valuable to investors. The outcome will also have implications for the size of any additional stimulus coming out of Washington in the months ahead, with the Democrats likely to favor a larger spending package and Republicans something smaller.

Currently, both sides are talking again after failing to reach a deal prior to the election — Speaker Pelosi refused what was reportedly a $1.8 Trillion package from the White House at that time. The size of additional relief remains in question, however, with the same hurdles as prior to the election with Democrats favoring additional direct aid to state and local governments and Republicans pushing for additional liability relief for businesses. A bipartisan coalition of legislators has proposed a $908 billion stimulus package that tries to address these issues. We think it has a decent chance of passing during the lame duck session of Congress, potentially as part of a bill to fund the government past December 18. We are also monitoring the news for any updates to programs funded under the CARES Act (e.g., the Municipal Liquidity Facility) which are due to sunset on December 31. President-elect Biden has shown a willingness to extend funding of many of these programs into 2021, but will have to work with Congress to make this happen. With COVID spiking in many regions and vaccines still months away for much of the population, it’s clear the economy can use additional support over the next few quarters.

What about key referendums nationwide?

In addition to the Federal elections, there were a number of states with key referendum measures on the ballot, including:

• An Illinois state graduated income tax amendment that was defeated by a not-insignificant amount of 53.4% to 46.6%. The state constitutional amendment would have raised revenues by more than $3 billion annually to help plug multi-billion-dollar budget hole projections. The individual state income tax rate remains at a flat 4.95% for now. The rate had been 3.75% from 2015 to 2017, and it was 5% from 2011 to 2014. State legislators will have to convene to present Governor Pritzker with other revenue enhancing alternatives, including a potentially higher flat rate on personal income taxes. The State’s ratings are hanging in at investment grade level with Moody’s at Baa3 and S&P at BBB- with negative outlooks.

• In California, Proposition 15 was defeated. Passage would have repealed a portion of 1978’s Proposition 13 which capped property taxes at one percent of purchase price and allowed some properties to be taxed at current market value. The repeal would have affected industrial and commercial properties worth $3 million or more and would have generated as much as $11.5 billion in additional revenue to local governments and schools. The Proposition faced strong headwinds from the slumping economy, but it’s likely we will see similar attempts in the future as schools and local governments become too dependent on more volatile sales and income taxes. As municipal bond managers, we like what has been a more stable revenue stream that property taxes can provide. The State’s ratings are firmly in investment grade territory with Moody’s at Aa2 and S&P at AA- with stable outlooks.

• In Colorado, voters handily approved Proposition 116 which will lower the state individual and corporate income tax rate from 4.63% to 4.55%. The hit to state revenues from the tax cut will be approximately $200 million this fiscal year and will require reductions elsewhere in the state’s budget. The state now faces tough budget decisions when more people than ever are relying on state services to get through the pandemic. Colorado’s issuer rating is Aa1 from Moody’s and AA from S&P and both have stable outlooks for the state’s credit quality.

• Lastly, to find other sources of revenue in these difficult times, five states asked voters to legalize certain uses of cannabis — Montana, Arizona, New Jersey, South Dakota, and Mississippi. With various stipulations, voters in each state approved the legalization. This trend will likely continue as states look to fill budget gaps. For example, as of November, the state of Illinois has collected almost $150 million in tax revenue from cannabis sales in the first 11 months of legalization. This is on sales of about $580 million and is closing in on how much the state collects from liquor taxes. This potential increase in revenues will be hard for other states to ignore.

Positioning

On the short end of the yield curve, the lower-for-longer interest rate environment is likely to continue through next year at a minimum. The Fed has signaled its commitment to continue to provide ample accommodation until the economy gets on more solid footing with vaccines rolling out through 2021. As much as we are heartened following the progress on the vaccine front, we do feel the market is somewhat overly optimistic on the pace of the recovery to normality. With this optimistic outlook, the market has also been more concerned with future inflation rates. We have seen a notable uptick in mainstream news on why inflation may return in 2021. However, as investment professionals, we’ve seen as many Wall Street reports on an “inflation mirage” for 2021. There are arguments both for and against rising inflation, but we believe a spurt of higher inflation in the first half of 2021 may be capped by slack in a badly beaten labor market.

As such, we favor keeping portfolio durations slightly longer than benchmark with much of our exposure on the long-end of the curve invested in higher income sectors such as healthcare and transportation and underweight more defensive sectors like state general obligation bonds and local school district debt. We expect the lower quality, higher income sectors to potentially outperform through 2021 as the economy slowly recovers, just as they have over the past few months.

Current Positioning and Outlook

Duration
•  Maintaining slightly longer duration relative to benchmark, with some caveats.
     – The Fed has anchored interest rates on the short end of the curve at the zero lower bound through the next several quarters and will tolerate periods of higher inflation.
    – Spurts of higher inflation and rising inflation expectations will put upward pressure on long-term interest rates.
   – Long municipal bond yields will be pressured higher with treasury yields and could underperform as they are relatively rich at this time.
   – Our longer duration will be focused on the A-rated and BBB-rated sectors which have room to tighten.

Yield curve
•  The municipal yield curve bullishly flattened in November with the two-year spot yield falling five basis points as the 30-year spot fell 29 basis points. The 10-year spot fell 23 basis points and is only seven basis points higher than its historical low of 0.64% yield.
   – In fact, most of the maturities across the municipal curve are remarkably close to their historic lows — in our opinion, a good reason to move our portfolios’ interest rate sensitivity lower (i.e., shorter duration).
   – The weekly municipal floating rate index (SIFMA) is 0.09% (12/9/20) versus 1.11% a year ago.
   – We think SIFMA will remain at these extremely low levels for the foreseeable future. For reference, SIFMA was below 0.40% from June 2009 through March 2015. The dividend yield on tax-free money market funds will likely remain tight to SIFMA.
   – Ultra-short muni funds may be a good alternative to pursue additional yield vs. a tax-free money market fund.

Credit and structure
•  While credit quality spreads have tightened significantly since March, they still remain elevated versus historical averages, particularly for BBB-rated bonds and high yield munis, as the upper credit tiers (AAA and AA) have outperformed substantially year to date.
   – We can see this in year-to-date spreads between the AA and BBB-rated indices. The Bloomberg AA Muni Index returned 4.79% YTD through November 30 while the BBB Muni Index returned 2.79%. However, in the month of November, the BBB Index returned 2.03% versus 1.37% for the AA Index. We expect more BBB outperformance over the next several months as quality spreads tighten in a slowly improving economy.
•  Sector and credit selection will be the primary drivers of performance over the next few quarters and will require fundamental and technical expertise to navigate.
•  All sectors should have offerings that provide value. We will be analyzing the risk/reward of many different investments, notwithstanding the potential for heightened credit volatility.

Geography and sector
•  The sectors hardest hit financially by the spring lockdowns have been those most reliant on the consumer — hospitals, toll roads, and airports. These sectors continue to provide some of the best opportunities for relative price improvement over the next few quarters but could be volatile as COVID cases are currently spiking in much of the U.S. as we head into the winter.

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Disclosures

All investments involve risk, including the possible loss of principal.

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 the funds to increased loss of principal.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall.

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

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

The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

Bloomberg Barclays 1-10 Year Blend Municipal Bond Index is an unmanaged index of municipal bonds rated BBB or better with 1 to 12 years to maturity.

The S&P 500® Index is an unmanaged index of large-cap common stocks.

Investments cannot be made in an index.

BMO Funds receives credit quality ratings on underlying securities of the Fund from Bloomberg Barclays using ratings from Moody’s Investors Service (Moody’s), Fitch Ratings (Fitch) and Standard & Poor’s (S&P).
If the ratings vary by agency, the following methodology is used: If Moody’s, S&P and Fitch all provide a credit rating, the rating used is the median of the three agency ratings. If only two agencies provide ratings, the rating used is the more conservative rating. If only one agency provides a rating, the rating reflects that agency’s rating. Securities that are not rated by any of the three agencies are reflected as such in the breakdown. Ratings and portfolio credit quality may change over time. Unrated securities do not necessarily indicate low quality. The Fund itself has not been rated by an independent rating agency.

Obligations rated Aa by Moodys are judged to be of high quality and are subject to very low credit risk.

Obligations rated A by Moodys are judged to be upper-medium grade and are subject to low credit risk.

Obligations rated Baa by Moodys are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.

An obligation rated ‘AA’ by S&P differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitments on the obligation is very strong. An obligation rated ‘BBB’ by S&P exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to weaken the obligor’s capacity to meet its financial commitments on the obligation.

Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories.

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Bps (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

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.

Interest income from tax-exempt investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.

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 not subject to federal income tax but may be subject to AMT, state or local taxes.

You should consider the Fund’s investment objectives, risks, charges and expenses carefully before investing. For a prospectus, which contains this and other information about the BMO Funds, call 1-800-236-3863. Please read it carefully before investing.

BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors.

Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).
BMO Financial Group is a service mark of Bank of Montreal (BMO). BMO Asset Management Corp. is the investment adviser to the BMO Funds. BMO Funds are distributed by Foreside Financial Services, LLC.
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