Municipal Fixed Income

More gasoline on the fire of recovery

The U.S. $1.9 trillion American Rescue Plan has now passed, which includes at least $650 billion in unprecedented muni-centric aid – an illustration of how far we’ve come over the last 12 months of the pandemic.
April 2021

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What's new in munis?

The U.S. $1.9 trillion American Rescue Plan has now passed, which includes at least $650 billion in unprecedented muni-centric aid – an illustration of how far we’ve come over the last 12 months of the pandemic.

What this means for investors is that any concerns over investment grade municipal bonds (munis) are likely off the table for now, with the new funding providing more than enough backstop for state and local governments to overcome the slowdown, especially since previous stimulus has not yet been depleted. Case in point: Moody’s has upgraded its stance on state and locals to neutral from negative, while shifting to a stable outlook on airport bonds.

Of the new muni package, $350 billion will be directed to states/locals/territories; $129 billion is allocated to K-12 education; $40 billion for higher education; $30 billion for mass transit; and $8 billion for airports. While larger population states will see higher aid totals, many smaller ones will benefit more relative to their population, tax revenue base and GF expenditures, as every state is to receive at least $500 million – with no deadline on spending. In total, across the March 2020 CARES Act, the December 2020 stimulus and latest coronavirus relief package, we estimate roughly $1.2 trillion of muni-related aid provisions across the various sub-sectors.

It’s likely that as we move to the second budget reconciliation package with infrastructure as a focus, we will see both corporate and individual tax rates move higher. As a result, we can expect increased demand for tax-exempt munis and potentially more “crossover buyers”, including banks and insurance companies, as that tax break becomes more valuable if the Biden administration succeeds in getting tax increases through Congress.

State-by-State breakdown of the American Rescue Plan (combined state and local aid in billions)

Map showing the state by state breakdown of the American Rescue Plan as of March 2021

Source: JPMorgan, March 2021.

Where we see value now

The latest rescue funds, combined with widespread vaccine rollouts, will position muni spreads to narrow as the economy improves, particularly for A and BBB-rated bonds where we remain overweight. Lower investment grade spreads remain elevated compared to pre-pandemic averages, and we believe they offer the best income advantage this year versus the Bloomberg Barclays 1-15 Year Muni blend Index benchmark. Year-to-date (YTD) performance is now strongest in the lower investment grade and high yield areas, and we anticipate more BBB outperformance over the next several months as lower quality spreads continue to tighten.

We’re also seeing munis respond to the steepening of the US Treasuries yield curve, which is why we’ve moved to a slightly shorter duration stance. Investors are baking in higher inflation – at least for a transitory period, and we see more downside risks to interest rate exposure in longer maturities over the next few months. However, there is still significant slack in the labor market, and Federal  Reserve Chairman Jerome Powell has made it clear the central bank is willing tolet inflation run north of 2% in an effort to disabuse investors of any tightening in 2022.

What’s Ahead

As anticipated, primary issuance is picking up in April, with more supply coming into the market even with the approval of new stimulus, as it will take some time for these funds to be dispersed (there is still unused budget from the CARES Act). We also expect some state and local governments will restart municipal projects that had been postponed due to market uncertainty in 2020.

Another factor that could put upward pressure on tax-exempt supply is the potential tax code change to once again allow for tax-exempt advance refundings (currently prohibited under the 2017 tax code changes), which could become a tool for issuers again to manage their finances as part of the second reconciliation bill.

Meanwhile, as the personal income tax deadline approaches (now extended to May 17), expect investors to sell shorter-dated municipals to pay tax bills, potentially causing some seasonal upward movement in the SIFMA weekly floating rate index.

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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 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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