Municipal Fixed Income

Why BBB munis are an A+ opportunity in our books

Investment grade muni spreads tightened significantly since March, but still remain elevated in some areas versus historical averages.
February 2021

What’s new in munis?

There’s no denying that municipal bonds (munis) – like most asset classes – experienced a broad recovery in the latter half of 2020, but there is still value hidden in the right pockets as the economy returns to its “new normal” in 2021.

Last Spring, munis experienced a massive dislocation driven by investor fears of a revenue collapse at the state and local government level, particularly for longer-dated and lower-rated muni bonds. However, the collapse – by and large – never happened. The reserves that many municipal issuers built up over the past decade buffered the pandemic’s initial impact on various revenues.

As fears waned and fundamentals prevailed, investment grade muni spreads tightened significantly since March, but still remain elevated in some areas versus historical averages, particularly for BBB-rated bonds and high yield munis. And where there is room for spreads to narrow, there is opportunity to be realized. As such, we believe sector and credit selection will be the primary drivers of performance for munis over the next few quarters.

AAA-rated Muni GO Yield minus BBB Muni Hospital 10 Year

Chart image showing AAA-rated Muni GO Yield minus BBB Muni Hospital 10-year from Jan 19 2018 to Jan 19 2021

Source: Bloomberg.

Where we see value now

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 our benchmark. Spreads in these areas remain wider than they were 12 months ago, and as vaccines become more widely distributed and the economy returns to a more pre-pandemic state, we expect these displaced bonds will continue to tighten in the months ahead. Holding these lower investment grade, longer dated maturities within our portfolios aligns with our income bias, adding incremental, tax-free spread across various securities and positioning the portfolio strongly over the entire market cycle.

Airports

Airports are an area we are closely watching for buying opportunities, as despite the current negative sentiment, people are commuting more than they were six months ago – a trend which we believe will pick up nationwide as greater vaccine adoption and warmer weather boosts travel. Moody’s expects 2021 enplanements to be at only 25% to 45% of 2019 volumes in the first half of the year, before recovering to roughly 60% in the latter half. U.S. airports are also well positioned for the current disruption, as most had strong liquidity positions prior to the virus outbreak and have received federal stimulus from the Coronavirus Aid, Relief and Economic Security (CARES) Act and the Relief Bill in December, while simultaneously trimming operating expenses and refinancing debt.

Importantly, airports with high international and business traffic will likely be the slowest to recover – and this is where we can pick up spread at the individual security level, diversifying our position across a number of transit hubs, from Chicago O’Hare to Denver International. On average, we like to keep exposure to a single municipal issuer under half-a-percent within our portfolios.

Looking forward

On the back of COVID relief programs and more stimulus in the pipeline, our expectation is that we will see a steepening of the yield curve. While it’s not a perfect correlation, municipal bond yields typically track U.S. Treasuries. This is one reason why after tilting our portfolio slightly to longer duration for the better part of the last two years, we decided to shift to a neutral stance in the fourth quarter to remove some of that longer-end exposure to reduce interest rate risk. We sold some of the more highly rated bonds that are already trading at pre-COVID levels, including some AAA and AA credits, and maintained our overweight position in the A and BBB-rated sectors, which we think will outperform higher quality bonds over the next several months in a slowly improving economy.

Aside from the $350 billion in direct state and local aid expected from President Biden’s proposed $1.9 trillion COVID-19 relief package, the other major piece to watch for munis in the near-term will be the $170 billion planned to reopen schools and help districts comply with enhanced safety measures. With children back at in-school learning, mothers, fathers and caregivers can finally re-enter the workforce, which would strongly – and positively – impact economic growth in 2021.

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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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