Municipals Views—Q1 2021

    Franklin Templeton Fixed Income

    Since the record outflows from the municipal bond market in March 2020, flows have returned as investors seek out strong tax-adjusted returns. 2020 is a record-setting year for new issue municipal bond supply, and the overwhelming growth in primary municipal bond activity is due to traditional tax-free bond issuers’ increased use. Issuers have increasingly turned to taxable muni bond structures because they provide the ability to refund previous issuance with low all-in yields and at times, reduced covenants. This taxable issuance has limited the net supply in the tax-exempt market. Scant tax-free supply paired with a healthy demand for tax-exempt bonds has driven strong year-to-date performance. Interestingly, the lack of supply has supported tax-free muni performance, while growth in supply has helped taxable municipal bonds—where supply has created demand. A relatively small universe of taxable munis with lower liquidity and an evolving buying base were alleviated through increased supply of taxable municipal bonds.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    We project demand to remain high across both taxable and tax-free munis, which should support overall muni-bond valuations. Most market participants assign a high correlation of the demand for tax-free municipal bonds with growth in top quintile household income in the United States (the second chart). Despite the headwinds of a low interest-rate environment, the growth in higher household incomes will likely preserve the trend of positive flows into the municipal bond market as higher-earning investors seek the safety and tax shelter they can provide.

    Despite the ongoing COVID-19 pandemic and the resulting economic downturn, we believe a second COVID-19- driven market disruption is unlikely to unfold in the muni bond market. It is important to note that the muni market is highly fragmented and littered with idiosyncratic risk. Fracture points originate from many sources, including differing state laws, sector traits, ratings and quality, structure, covenants and security features, etc.

    Our view continues to call for positive tax exempt and taxable municipal bond performance; however, given that the recent back up in US Treasury prices has pushed both the 10- and three-year muni-to-Treasury ratio beneath 100%, we believe the value in the tax-exempt market is generally confined to investors with the ability to use the tax exemption. The taxable municipal bond market has value to investors looking for high-quality credit profiles, yields in excess of US Treasuries, and cannot utilize tax exemption. We believe investors in taxable municipal bonds can reap the benefits of high income and a strong credit profile while simultaneously participating in mild spread tightening. Due to the different dynamics at play, over the next 12 months our view for taxable muni investors is neutral with reasons for optimism, whereas for tax-free municipals, we have an outlook of neutral with reasons for concern.

    We continue to favor a highly rated, high quality, structurally liquid portfolio for multi-sector investors. Since the municipal market has the protection of a relatively steep yield curve, we believe duration in both taxable and tax-exempt selection are very client-centric decisions and thus we remain somewhat agnostic toward positioning. While we are biased toward the upper end of the high-grade municipal bond universe, there are a few spread opportunities in the lower end of the high-grade market that remain attractive. We recommend tactically harvesting from a select universe in the transportation, health care, and state general obligation sectors where some issuers’ debt remains at elevated spreads.

    Although national elections have historically had significant impact on the overall municipal bond market, we feel that “down ballot” races, including state and local elections, have larger implications on the credit climate that each muni bond issuer operates within. Initial indications from the 2020 federal elections show that neither party has been given a strong mandate. With Republicans maintaining their majority in the US Senate as we await runoff elections in Georgia and the reduction in the Democratic margin in the House of Representatives, it will be difficult for President-elect Biden to enact a number of his proposed more progressive policies. The muni bond market is more focused on the size and timing of additional fiscal support from the federal government. Issuers have advocated for direct support, including grants to bridge the gap in current and forecasted budgets. We anticipate an additional round of support to municipalities and states, but it will likely be delayed until the new administration takes office and will be smaller than the stimulus bill the House initially passed over the summer.

    When looking at elections at all levels, we look to understand sentiment changes, political priorities and prepare for the outcomes so we can take advantage of any potential opportunities that arise in the market. State and local elections are important because certain types of bonds require voter approval. Many state and local governments put tax measures on the ballot and, of course, elected officials govern state and local governments, approving budgets and providing government services. Therefore, we learn a lot from state and local elections.

    The impact of the shutdowns has had wide-ranging implications for most muni-bond issuers. Although revenue from tax receipts and usage fees have increased modestly as states reopen their economies, a significant portion of muni-bond issuers are still anticipating large budget deficits over the next several fiscal years. Municipalities and states that enter the period with overstretched budgets are seeing these issues amplified. In many instances, states, counties, and localities have balanced budget processes where running structural deficits are not possible. They are looking to increase revenues, through tax increases or federal government support, as well as cut their cost outlays. To avoid dramatic initial budget cuts, some issuers have implemented budgets that rely on either additional federal government support or stronger tax receipts. In the absence of these by mid-year, some states will have to reduce spending levels further to bring the budget back into alignment.

    Increasing taxes on the underlying populations will have a positive effect on revenue in the short term, but it cannot be viewed in a vacuum. Overburdening taxpayers can lead to significant changes to demographic patterns where individuals move away from higher tax areas toward cities and states that have lower all-in costs. This can exasperate underlying fiscal issues, as fewer taxpayers are left to fund operations and service the government debt. When looking at tax rates, we incorporate the total ability to pay from the taxpayer standpoint to identify areas that will likely suffer the consequences of moving tax rates higher.

    Looking into 2021, we still see underlying credit fundamentals of muni-bond issuers as the primary determinate of relative value. Our dedicated muni-bond credit research team is focused on identifying sectors and issuers that have strong credit fundamentals that can weather the current downturn. Additionally, we are prepared to take advantage of mispricing in some of the more challenged areas of the market, such as sectors and issuers where the investing public appears still tentative but the prospects for improving prices look constructive due to government support, essential function, and/or a lack of understanding of the underlying security.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

    Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.