Municipal Fixed Income

The first round of a heavyweight infrastructure title fight

We can expect a final infrastructure bill’s passage will drag on for some time, but each party has at least laid their cards on the table, providing some clarity for the potential negotiations ahead.
May 2021

What’s new in munis?

The Republicans recently unveiled their U.S. $568 billion infrastructure counter-proposal to the Biden administration’s $2.25 trillion American Jobs Plan (which includes $1.3 trillion for physical infrastructure).  While it is roughly a quarter of the size of President Biden’s package, it sets a significant amount of funds toward “traditional infrastructure”, with plans to spend $299 billion on roads and bridges, $61 billion on public transit systems, and $65 billion on broadband expansion, among other investments. Meanwhile, President Biden’s proposal also includes allocations for such non-traditional infrastructure investments such as long-term care and alternative energy, which will likely mean some spirited debate over the coming months. As a result, we can expect the final bill’s passage will drag on for some time, likely through the summer (unlike the COVID relief packages), but each party has at least laid their cards on the table, providing some clarity for the potential negotiations ahead.

Many anticipate that climate will be a central part of the conversation since President Biden just pledged at the recent virtual climate summit to cut U.S. greenhouse gas emissions 50% by 2030. If renewable energy infrastructure is included in the final package to help achieve this goal, we can expect municipal green-designated bond issuance to potentially double in 2021 over 2020’s total of $20 billion.

With the current environment in Washington, there may also be implications for the mix of tax-exempt vs. taxable municipal supply later this year and into 2022, as a “BABs 2.0” program is rumored to have bipartisan support (Build America Bonds (BABs) funded just over $180B in infrastructure spending following the Great Financial Crisis in 2009-10). This would redirect a substantial portion of infrastructure issuance to taxable bonds, which would keep tax-exempt supply well-controlled. It could also drive municipal bond (munis) demand from non-traditional muni investors, such as foreign investors due to the spread pick-up compared to available corporate or sovereign debt bonds.

Where we see value now

As the economy continues its recovery, with the first reading of U.S. Q1 GDP clocking in at an annualized rate of 6.4%, we think lower investment grade and high yield municipal debt are still best positioned for outperformance, with BBB credit spreads remaining 25-40 basis points wider than pre-pandemic levels, depending on sector. With room to tighten further, we remain overweight in A and BBB rated bonds relative to the Barclays 1-15 Year Muni blend Index benchmark.

Bloomberg Barclays Index returns by credit tier

Chart showing month-to-date and year-to-date Bloomberg Barclays index returns by credit tier as of April 30 2021

Source: Bloomberg Barclays, as of March 31, 2021.

We continue to believe that consumer-reliant sectors, including hospitals, toll roads and airports (some of the hardest hit financially by the 2020 lockdowns) provide some of the best opportunities for relative price improvement over the next few quarters, particularly as more than 50% of U.S. adults have received at least one dose of the COVID-19 vaccine as of April 18, 2021, according to the Centers for Disease Control and Prevention. Specifically, the higher education sector is attractive, as many U.S. schools prepare for vaccinated students to return for in-person learning this fall, potentially increasing revenue for institutions with a full campus versus the 2020-21 academic year.

In terms of duration, we’ve moved to a slightly shorter stance relative to the Barclays 1-15 Year Muni blend Index benchmark, as we see more downside risks to interest rate exposure in longer maturities over the next few months. Inflation is picking up, and we should see some upward pressure on long-term rates over the course of the year. Strong demand with record year-to-date inflows (according to Refinitiv, as of April 21, 2021) , and negative net new supply of tax-exempt bonds, has kept munis extremely rich against U.S. Treasuries. However, the passing of an infrastructure bill could potentially cause some increase in issuance during 2022.

What’s ahead

Even with supply potentially ticking up though, one catalyst that could keep munis in demand is the proposed increase in both individual and corporate tax rates, including taxing capital gains at ordinary income tax rates for those bringing in more than $1 million per year. If rates increase as expected to levels unseen since the 1970s (likely sometime in 2022), demand for tax-exempt munis will likely remain strong, particularly for high-income earners. 

The elimination of the current SALT cap, currently at $10,000, is also likely to be contentious, since many Democratic legislators are pushing for its repeal, despite evidence suggesting most of the benefit will go to higher income earners rather than the middle class.  This, along with the lifting of the current prohibition on tax-exempt advance refundings (restricted under the 2017 tax code changes), are expected to be two of the larger discussion points during the infrastructure bill negotiations. The reinstatement of tax-exempt advance refundings is estimated to save muni issuers and taxpayers more than $2.35 billion annually.

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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 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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