What's new in munis?
The Senate finally passed the U.S. $1.2 trillion bipartisan infrastructure package on August 10, which includes U.S. $550 billion of new spending, meaning it now moves to the House of Representatives for passage. While the move marks progress, it’s still stirring disquiet in the marketplace.
Speaker Nancy Pelosi had been pushing back on a separate track for this bill, wanting to couple it with a vote on the larger U.S. $3.5 trillion budget resolution. The latter proposal, which is sponsored by the Democrats and focuses more on social infrastructure and green initiatives, will ultimately have to be passed through Congressional budget reconciliation to gain approval without Republican votes, but a vote on the budget resolution is the first procedural step in this process. Under Senate rules, the budget reconciliation process can’t begin until the new federal fiscal year starts on October 1.
However, Pelosi faced opposition from moderates in her party about the coupling idea (and the potential delay of the bipartisan infrastructure agreement), as well as the hefty price tag of the budget resolution. Several Democrats, including President Biden, wanted to see the US$3.5 trillion proposal pass on its own merit, while other progressive members felt that coupling was the best chance to move it through Congress. As a compromise, Speaker Pelosi held a vote on the budget resolution on August 24, passing the House by a 220-212 vote. To satisfy House moderates, the Speaker pledged to hold a vote on the bipartisan infrastructure package by September 27, ahead of the budget reconciliation negotiations.
While the funding for the bipartisan deal is still being negotiated, the proposal calls for no increase in corporate or personal income tax rates. Any major tax reform will have to wait for the budget reconciliation process in Q4, which at present includes higher personal income tax rates for those earning in excess of U.S. $400,000, along with higher corporate tax rates The prospect of higher tax rates is one of the factors keeping investor demand for municipal bonds quite strong this year.
Meanwhile, minutes from the July Federal Open Market Committee (FOMC) meeting suggest that the tapering discussion is well underway, and many market participants await Fed Chair Powell’s speech on August 27 at the Jackson Hole Symposium and the September FOMC meeting as additional data points related to the potential start of the Fed taper. The general consensus is that it will begin in the Fall, as most Fed governors prefer to see this completed before contemplating rate increases sometime next year. In fact, a formal plan reducing the current purchase program of $80 billion of U.S. Treasury securities and $40 billion of mortgage-backed securities each month could be announced as early as late September.
Where we see value now
The municipal bonds (munis) market has come a long way over the last 15 months in terms of credit spreads, with likely little room to move significantly lower (see chart below).
The chart above shows BBB-AAA spreads from November of 1993 through July 31, 2021. Source: Bloomberg Barclays Indices.
While relative value remains difficult to find, the situation has improved on the long-end of the curve. Since the July jobs report on August 6, there has been some steepening of the AAA curve, though rates remain near historic lows. The best value now versus US Treasuries is in the 10- and 30-year spots, where munis are less rich than earlier this year, but still comparatively rich to averages seen since the Tax Cuts and Jobs Act of 2017 and arguably more vulnerable to persistent inflation That said, a further backup in rates is anticipated as the economy continues to recover.
Meanwhile, demand for munis continues to overwhelm current supply, which is up only 8% year-over-year through July 31. However, we anticipate the typical seasonal pick-up after Labor Day should bring additional spread opportunities to put new money to work. With some upward pressure on rates, particularly at the longer end of the curve, we will continue to maintain slightly shorter duration across our portfolios versus the applicable benchmarks – waiting for the expected increase in supply. Per Bloomberg data, September maturities are estimated at just over $19 billion, which would be the lowest monthly total since April 2020. Along with the seasonal pickup in issuance, this month could finally bring some relief to the negative net issuance observed over the June-August period.
While the Delta variant has increased investor anxiety, we believe it will likely only delay the recovery – not derail it. Recent Morgan Stanley research, which analyzed data from regions in Europe, estimated the U.S. Delta peak could arrive in the next few weeks, and, if that happens, case count declines will begin this Fall. As we get deeper into the pandemic, people are learning how to live with rapidly changing conditions, as evidenced by continued strong airport and travel activity, but the start of a new school year across the country over the next few weeks could present new challenges in managing the virus.
Municipal investors should also keep tabs on any proposals for a new Build America Bonds (BABs 2.0) program, or the lifting of a current prohibition on tax-exempt advance refunding – neither of which are currently part of the US$1.2 trillion bipartisan infrastructure bill. Given where rates stand now, there is pushback on BABs 2.0 because the federal government would have to subsidize as much as 50% of the coupons on these taxable bonds, dampening appetite for the plan due to cost. However, this could all change swiftly, and investors should watch for developments on this front as part of the budget reconciliation process focusing on the social infrastructure package later this year.
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.