Inflation: transitory, persistent – or both?

What’s new in munis?

While many economic observers, including the Federal Reserve (the Fed), have said that U.S. inflation is likely to be transitory, it may not actually be that simple – especially after the latest CPI numbers. April CPI’s core reading surprised to the upside (+3%), with the highest year-over-year increase since 1996. Fortunately, we’ve been modestly defensive in our municipal bond (munis) portfolios because our view is that munis – at least in the short run – can be pulled along with U.S. Treasury yields in either direction.

One important catalyst for upward pressure on Treasury yields (and likely muni yields) is the potential tapering of the Fed’s asset purchases in the near future if the economic recovery continues. The recent rise in inflation begs the question of how long the Fed can both maintain zero fed funds rates and still undertake quantitative easing (QE). April meeting minutes of the Federal Open Market Committee (FOMC) suggested that some members are eager to discuss reducing bond buying, with Fed President Kaplan among the more vocal of the group.

Ultimately, the nature of inflation will depend on the pace of the nation’s jobs recovery, as employment is still down approximately 8 million compared to pre-pandemic numbers, much of which is concentrated in the services sector. Already, 22 U.S. states have said they will no longer accept enhanced unemployment benefits from the Federal government in an effort to encourage some of those individuals displaced during the pandemic to return more quickly to the workforce. Some states have even proposed lump-sum payments to those who find work, with many states now operating with a budget surplus as a result of better-than-anticipated sales tax revenues and ample monetary aid during the pandemic. Add to this, companies are starting to adjust base wages and/or offering sign-on bonuses to provide incentives to potential new employees. It will likely take a number of months to assess the positive or negative impact of these steps to jump-start employment.

Meanwhile, both Republicans and Democrats are continuing talks on the infrastructure bill. On May 21, President Biden reduced his proposed package from U.S. $2.3 trillion to U.S. $1.7 trillion, in an effort to win over both Republican and moderate Democratic support, and shortly after, the Republicans boosted their counter-proposal to U.S. $928 billion from their initial U.S. $568 billion package. While progress has been made, the two sides remain at odds over funding. The Republican counterproposal plans to maintain current tax rates established in 2017, and assumes U.S. $495 billion of highway and mass transit spending over the next eight years that has already been appropriated in its total cost, along with potentially reallocating unused funds from prior Covid relief bills to help finance the package. Democrats, on the other hand, intend to increase corporate and personal tax rates to pay for their plan, which would be U.S. $1.7 trillion in new spending as currently proposed. More news on this is expected over the next month, as the House is hoping to vote on a package before the July 4 recess, which may prove to be an aggressive timeline.

Where we see value now

On the technical side, muni supply and demand dynamics are still supportive and pockets of value remain limited with industry flows at U.S. $46.6 billion year-to-date (source: Refinitiv Lipper, as of May 19, 2021), marking the highest level to start a year since the dawn of the Refinitiv data series in 1992. Meanwhile, tax-exempt primary gross issuance is up only 10% year-over-year as of May 14, 2021. The summer also tends to be seasonally strong for muni coupons and bond redemptions. Estimates are predicting U.S. $130-135 billion of coupons and redemptions over the June to August period, which will likely keep munis persistently rich over the summer months and could extend favorable demand/supply technicals into the fall. This is another reason to maintain a somewhat defensive stance, and why we’re keeping duration slightly short of our Barclays 1-15 Year Muni blend Index benchmark, with the intent to add spread to our portfolios when better opportunities arise if rates eventually respond to higher inflation and/or increased supply. Any additional issuance resulting from the passing of an infrastructure bill could help to alleviate rich conditions, but investors are more likely to have to contend with this in 2022.

In terms of specific muni credit focus, the Illinois Supreme Court reversed the lower court decision on the Tillman vs. Pritzker case, which contended that U.S. $14.3 billion in state general obligation bonds had been issued illegally. As a result, these challenged bonds rallied along with Illinois GO debt in general, which coincided with positive news that the state will seize on its recent revenue boost to repay the remaining U.S. $2 billion loan borrowed from the Treasury Department’s Municipal Liquidity Facility earlier than anticipated. This is expected to result in as much as U.S. $100 million in interest savings for Illinois and is an important step in its efforts to improve its fiscal footing. The state is also due to hold its first large convention in nearly 18 months with the Chicago Auto Show returning to McCormick Place in July, which is significant for its economy in terms of tourism dollars – and a sign of a return to pre-pandemic life.

What’s ahead

Looking ahead, muni investors should keep their ear to the ground for news on the infrastructure bill, particularly the potential for both sides to agree on an extension to the current Highway Trust Fund authorization that expires on September 30. Doing so could go a long way towards funding traditional infrastructure needs at a minimum. If this compromise isn’t achieved, there is also bipartisan support for reinstating tax-exempt advance refundings (which were prohibited under the Tax Cut and Jobs Act of 2017), and for a new Build America Bonds (BABs 2.0) program, where interest rate payments on these taxable bonds would be subsidized by the Federal government. Both plans would help fund the infrastructure package, while simultaneously saving municipalities interest expense.

A BABs 2.0 program, in particular, would also open up munis to a wider audience, including foreign investors looking for income, making the asset class less reliant on the traditional U.S. high-net-worth retail buyer base. BABs funded just over $180 billion in infrastructure spending following the Great Financial Crisis in 2009-10, so the passing of another version would be meaningful if it comes to fruition. It would also redirect a substantial portion of infrastructure issuance to taxable bonds, which would keep tax-exempt supply well-controlled. 

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 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.

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.

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