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AAM Viewpoints – Inflation Might Be Transitory, But What About These Municipal Market Trends?


 

Ask a handful of people on the street if overall prices have been running higher, and you’re likely to get an earful of passionate responses. In fact, don’t be surprised if you inadvertently opened the floodgates to multiple examples of anecdotal evidence of how inflating prices have impacted their lives. Moving this discussion over from Main Street to Wall Street only intensifies the ongoing inflation debate. While the Federal Reserve continues to prescribe to the notion that higher prices are only transitory in nature, there are scores of retail and institutional investors who believe and would tell you otherwise. Regardless of one’s stance, there is no doubt that this “transitory versus persistent” debate is likely to be a defining theme for both equity and fixed income markets for the foreseeable future.

Although far from immune to inflationary forces or Federal tapering, the municipal bond market continues to be insulated from broad market volatility and has, at times, traded independently from its taxable counterparts. With broad municipals outpacing Treasuries by more than 300 bps (basis points) on a year-to-date (YTD) basis as of August 18, many investors are beginning to question if the factors behind this outperformance have staying power to carry over into 2022. Let’s examine the more prominent market trends to determine whether they are themselves transitory or perhaps exhibit longer lasting or persistent attributes:

Net Negative Tax-Exempt Supply

Similar to how the world is currently grappling with shortages of all sorts, spanning from semiconductor chips to labor, municipal bond investors have been subject to a shortage of their own for nearly two years now: too much money is simply chasing too few bonds. Ironically, even though YTD issuance through July 30 is up 4% versus last year’s pace, approximately 25% of that total has been coming to the market as taxable deals. Over the last 25 years – save for the 2009-2010 period when the Build America Bonds taxable bond program was created – the market has been accustomed to seeing taxable supply represent closer to 10% of issuance. That said, the emergence of taxable issuance has provided issuers with the following:

  1. Cost-effective refinancing in this low-rate environment
  2. Increased flexibility in how they can spend their sales proceeds
  3. Diversification of their investor base.

Transitory or Persistent? We believe it’s persistent. If state and local governments are still prohibited from issuing Tax-Exempt Advance Refunding bonds, we believe these constrained supply conditions, where taxable issuance eats into tax-exempt supply, are likely to persist for municipal bond investors into the new year. Even if the upcoming Congressional budget bill excludes an infrastructure financing provision, much like the Build America Bonds program, we believe taxable municipals are here to stay which means traditional tax-exempt bond valuations should continue to be supported by scarcity.

Historically Low Municipal-to-Treasury Ratios

Ever since the Biden administration’s trillion-dollar investment plans were paired with prospects of higher individual and corporate taxes, demand for tax-exempt paper has been on a whole other level. YTD weekly average inflows of approximately $1.9 billion into municipal bond mutual funds and exchange-traded funds (ETFs) have totaled more than 2.5x the weekly average intake of $716 million from the previous four years (FHN Financial). As a result, Municipal-to-Treasury ratios, which compares rates of municipal bonds with those of U.S. Treasuries, have been trading near historic lows almost all year long. Ratios have moderated in recent weeks with the 10-year trading around 70% of Treasuries (as of this writing) but relative to their historic averages of 90% to 100%, they still leave much to be desired.

Transitory or Persistent? We believe it’s persistent but expect modest adjustments. Even if lawmakers are unsuccessful in raising taxes this year, ratios should remain relatively rangebound. As long as tax rates do not fall from current levels, the only thing that we would view as transitory is a municipal market correction itself. Should ratios widen out toward their historic norms, we would consider these conditions a potential buy.

Credit Spreads Tightening to New Lows

The perfect storm of unprecedented fiscal aid, accommodative monetary policy, and good old-fashioned economic growth have continued to propel municipal credit spreads toward new lows. Fueled by an insatiable appetite for yield, Municipal High Yield bonds have been outperforming virtually all other fixed income asset classes by a wide margin. According to Bloomberg, option-adjusted spreads for broad municipals have fallen to 40 bps, well below the historic average of 72 bps. At this point, the market is trading at or even tighter than pre-COVID-19 levels with little to no regard for the delta variant.

 

Municipal Option Adjusted Spreads

municipal option adjusted spreadsSource: Bloomberg

Transitory or Persistent? We believe it’s transitory. While credit spreads remain adequately supported at current levels, the days of investors capturing massive gains from record tightening appear limited at best. Although state and local government budgets may be bogged down by pandemic-related costs on a daily basis, more and more of them continue to report revenue surpluses. In fact, several states have not even spent their relief allocations from the American Rescue Plan. Meanwhile, municipal issuers linked to the country’s infrastructure, particularly within the mass transit and airport sectors, are expected to receive additional aid assuming the latest infrastructure bill continues to move forward. Echoing the comments of Len Reininger in his latest article Credit: What Can Possibly Go Wrong, in an environment in which credit is priced to absolute perfection, one should not be too complacent.

Growth of Municipal ETFs

Municipal bond ETFs have collected $14.1 billion of inflows on a YTD basis and are on pace to easily eclipse the $14.5 billion record total amassed last year. Liquidity, low costs, and low barriers to entry are among the several reasons why investors have been increasingly drawn toward municipal ETFs. For investors looking to add near-instant exposure to municipals, especially in today’s supply-challenged market, ETFs may prove useful in this capacity. That said, this type of instant gratification goes both ways and has led to outsized volatility during periods of market weakness. When investors with long-term goals are sharing the same investment vehicle as those with short-term objectives, the ride could get bumpy occasionally.

Transitory or Persistent? We believe it’s persistent. Municipal ETFs provide new avenues that investors did not have available in the past. Given the exponential growth of the entire ETF industry in recent years, we expect investor inflows, as well as product selection within the municipal space, to expand going forward.

In essence, these market trends are all correlated, and one could even argue that the later three are simply byproducts of the first one: net negative supply. With the market headed toward the final four months of the year, historically a period of elevated volatility for the asset class, these trends might be put to the test. Assuming inflationary pressures remain nothing more than just a great debate, with these municipal-specific developments several months or even years in the making, perhaps it might take more than a few weeks of weaker technicals to disrupt these longer-lasting trends.

CRN: 2021-0809-9381 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit http://www.aamlive.com/.


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