Do municipal bonds have room to move higher?


Catherine Stienstra, Head of Municipal Bond Investments – Columbia Threadneedle Investments and Douglas Rangel, CFA Vice President, Fixed Income Client Portfolio Manager – Columbia Threadneedle Investments

In March 2020, municipal bonds suffered their largest selloff in history, but they have since recovered strongly. We believe munis will likely move higher in 2021, given the probability of increased taxes, renewed fiscal stimulus and continued credit spread-tightening as the U.S. economic recovery unfolds.

As the chart below highlights, significant demand drivers and undervalued portions of the market are creating a positive backdrop for this sector of the bond market.

Municipal bonds in 2021 chart

 

Positive prospects for municipal bonds

Policy proposals indicate the potential for higher federal tax rates among corporations and high-net-worth individuals. These two factors should mean tax-free muni bonds become attractive to investors again.

While higher tax rates may jump-start demand and lift prices, additional government stimulus could also lead to improved underlying credit. The initial two rounds of stimulus last year were a lifeline to essential areas of the economy — including hospitals, transportation, small businesses and consumers — but state and local governments were excluded from the aid. (City, county and state governments did receive direct aid in the March 2021 pandemic relief package.)

Despite concerns at the height of the pandemic, most states did not experience the tax-revenue shortfalls they expected.

  • Personal income taxes were collected from higher wage earners, as job losses were primarily contained in low-wage sectors.
  • Property tax collections also held steady. This was due to the strong residential housing market and the capital gains windfall resulting from a sharp rebound in the stock market.

If the current proposals from Washington are eventually signed into law, municipalities could benefit from additional direct federal aid. This would:

  • Help cover gaps in 2021 fiscal year budgets (ending June 30)
  • Allow states to conserve funds as they wait for the U.S. economy to rebound to pre-COVID levels
  • Mitigate broad concerns around municipal credit fundamentals

 

Considerations for investors

Bargain-seeking investors who focus solely on the higher-quality sectors might not think muni bonds are the right move at this stage. In our view, however, investors should consider these perspectives:

  • The highest-quality segment of the municipal market has rebounded more fully than other segments.
  • Higher taxes and/or direct fiscal support to state governments may increase demand for high-quality bonds. However, investors may be better served pursuing total return opportunities in lower-rated bonds, if appropriate for their risk tolerance.
  • Uneven ratings across market sectors and continued borrower uncertainty may create opportunities to drive returns with individual security selections.
  • It’s unlikely the path of recovery in the municipal bond market will be one-directional; any temporary weakness may be viewed as a muni-buying opportunity.

 

The bottom line

The past year has created market dislocations with incorrectly valued assets in some sectors of the market. As a result, the historic selloff of municipal bonds provides long-term investors with a compelling opportunity. Consulting your Ameriprise financial advisor and remaining flexible, selective and disciplined with your bond choices will be the name of the game.