Munis Are Expensive but Technicals Remain Favorable
While many of the taxable markets have generated negative returns this year, both the high quality and high yield municipal markets have generated positive returns (no guarantees that will continue, of course). State and local government finances are in better shape than many feared during COVID-19 shutdowns and many muni issuers are set to receive billions in federal aid. Thus, the fundamental backdrop for many muni issuers has improved recently. Yields, however, reflect that positive backdrop and are amongst the lowest they’ve ever been. As seen in the LPL Research Chart of the Day, the ratio of AAA municipal yields over 10-year Treasury yields, a common valuation metric, is significantly below the five-year average and around an all-time low.
“The municipal market has been a relatively good story for fixed income investors this year,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “And the continued need for tax-exempt income should help support prices.”
While valuations are high, the technical backdrop for municipal securities remains supportive, in our view. Investor flows into municipal mutual funds and ETFs have been strong with an estimated $43 billion of inflows year to date through May, which is the highest on record according to Lipper data. Currently, we’re entering a strong seasonal period when, historically, reinvestment money has outpaced new municipal bond issuance. Over the next three months, Bloomberg estimates $165 billion will be returned to bondholders (due to maturing bonds and interest payments) for reinvestment into the market, which is roughly $45 billion more than what is expected to come to market from new issuance. All that money chasing fewer investment opportunities should provide stability to bond prices, at least in the near-term.
That said, risks remain in the municipal market. While many state budgets are currently flush with cash, underfunded pensions are still an issue. A recent report by a global pension consultant shows that, as of June 30, 2020, state pension plans, in aggregate, were only 70% funded. Moreover, there have already been 76 distressed muni borrowers this year (mostly smaller issuers), which puts this year on track to exceed almost every year since 2012 in terms of impairments (2020 was worse due to COVID-19). Nonetheless, with strong tax revenues, billions in federal aid and strong flows into the market, municipal bonds should remain well bid, particularly in the near term.
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