Liquidity, Cash, and Demand Are Having Their Day in the Muni Sun!

Historical accounts of the Municipal Bond Market have generally been quite favorable, but this bastion of fixed income was never really characterized as the “sexiest” asset class out there. Munis largely perform as advertised; they provide resilient tax-efficiency, portfolio diversification, and, of course, above-average credit quality underscored by low default rates and relatively high recovery values. Taxable buyers, including cross-over and foreign investors enjoy these attributes, sans the tax-efficiency. For those of us whose bread is buttered by the Muni Bond Market, there is a special appreciation that may be lost on many of the casual observers of this $3.8 trillion corner of the investment universe. So it would seem that the Tax Cuts and Jobs Act (TCJA) elevated the allure of municipal securities, yet largely unintentionally. In addition to lowering individual and corporate tax rates, the TCJA removed the ability to float tax-exempt advance refunding bonds, a feature that ushered in a wave of taxable issuance reflecting 30% of overall primary market volume in 2020. Our Treasury market is telegraphing its concern over advancing inflationary expectations against a backdrop of expanding fiscal stimulus and stronger growth prospects, while at the same time Chair Powell and team are displaying little worry over rising inflationary pressure.

So where do munis fit in within the investment landscape? For some time now, our narrative has placed the asset class on technically-driven auto-pilot. Even at record expensive levels as illustrated by the lowest reported relative value ratios recently witnessed, demand for muni product continues unabated. Of course, it helps to have tempered new issue supply that provides for the other half of the supply/demand imbalance. We suspect that Central Bank liquidity efforts and hopeful prospects for muni fiscal relief have contributed support to the asset class. Despite the back-up (finally) in muni yields last week, market technicals remain in place and muni bond mutual fund find flows were decidedly positive with a $2 billion inflow for the last reported period, affirming still-sizeable amounts of sidelined cash.

Given the behavior of U.S. Treasury bond prices, we are seeing a further steepening of the yield curve and as indicated above, inflationary concerns are the driving force. Since the start of the new year, the Treasury yield curve (1YR/30YR) has steepened by 46 basis points, while the muni curve has steepened by 15 basis points. If it were not for the out-sized demand for product, we suspect that the muni yield curve would be exhibiting more noted steepening. While muni/treasury ratios have backed up and are now where they were at the end of January, they stood at 55% and 65% for the 10 and 30-year benchmarks respectively only recently. Presently at 64% and 71%, relative value ratios are still at historical lows.

At these current price levels, investors should logically question the value of acquiring new bonds. Having said this, we do not anticipate a meaningful technical shift in the muni market and so a more aggressive and sustained back up in yields has not made it to our radar screen. While this is a time where munis are breaking rank with UST, we do not maintain that munis will function in isolation of the Treasury market’s concerns over inflation, and we are hard pressed to believe that there is much more downward momentum for ratios. Aside from the inflation front, a broad credit event or a supply surge could catalyze a pronounced reversal in the ratio trajectory. As we have been advocating for several months now, muni investors should be reviewing their portfolios with a defensive strategy. The currently rich valuations and tight credit spreads help to facilitate upgrading portfolio credit quality in a systematic and thoughtful way. For certain investors, better relative value may be offered on taxable munis given the frothy prices of tax-exempts. Let’s also recognize that fund flows may be partly indicative of expectations for higher tax rates and a desire to shelter future income streams, thus supporting the demand for tax-exemption.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.