Stimulus and Infrastructure: Boon for Muni Bonds?


Stimulus and Infrastructure: Boon for Muni Bonds?

March 18, 2021

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Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: how the new US stimulus package and potential infrastructure plan could impact the municipal bond space...plus, why an array of tax changes may boost the relative value of munis.

Ben Barber, Director of Franklin Templeton Municipal Bonds, and Jennifer Johnston, Director of Research for Franklin Templeton Municipal Bonds…join Stephen Dover, Franklin Templeton’s Chief Market Strategist, for this conversation.

Transcript

Stephen Dover: Jennifer and Ben, let's just start off with how the pandemic really affected the muni market? First of all, in terms of revenues for governments for municipal bond area, what's happened in terms of the revenue over this past year.

Jennifer Johnston: So for state and local governments, their primary source of revenue comes from taxes. Depending on the level of government, depends on what your tax collections come from. But for states, they primarily really receive income taxes and sales taxes which, of course, both were affected by shelter in place policies. So, revenues basically fell off a cliff, right as shelter in place went into effect. And then as slowly, communities have been able to reopen, revenues are starting to come back.

Stephen Dover: So that varies a bit by state doesn't it? Haven't some states actually had increases or flat revenues and others less so?

Jennifer Johnston: Exactly. In general, for most states, they've actually seen performance over and above what they had initially anticipated. So what they had expected to be budgeted for the current fiscal year, they're seeing better than expected revenues, which is good news. Not all revenues have come back to the pre-pandemic levels, but it certainly is good news for the current fiscal year and as we start to enter budgeting season for next fiscal year.

Stephen Dover: So, we certainly wouldn't have expected that last March when we were looking at, all of us, you know, having the shock of going to shelter in place. So, despite that, or in addition to that, we've had a couple of stimulus packages. And we have a new, huge stimulus package. And so, how's that going to affect the municipal market?

Jennifer Johnston: So, the stimulus is very positive for the municipal market in several ways. Dating back to the CARES Act and as well as the December package, state and local governments benefited from a couple of programs, such as a COVID reimbursement program. So, the additional costs they were seeing from PPE, cleaning, those types of things, they could be reimbursed.

Additionally, the Fed started a Municipal Liquidity Facility which was meant to be a last resort, borrowing mechanism for states and certain local governments that might have had issues accessing the municipal market. And then also, for transit entities, they received a significant amount of stimulus to basically make up for lost farebox as well as tax revenues.

The thing that I think is most important about the package that was just passed, other than the sheer size of it, is that it actually included more flexible spending for the aid to state and local governments. So, they'll be able to now use it as what I call revenue replacement aid. So, for the tax revenues that are falling off because of the economy, this can replace that, helping stimulate spending.

Stephen Dover: Would you expect there to be more municipal bonds being issued because of the stimulus package? Does it affect the municipal bond market in that way?

Jennifer Johnston: It definitely could. Now that there's more revenue available, they can come back to issuing debt for capital purposes. We also saw a lot of refunding activity during the last six to eight months, as both people were taking advantage of low rates, as well as trying to delay or refinance debt service payments over the next few years. So the federal aid, as well as, just better than expected performance, should both contribute to it.

Stephen DoverBen, what might investors consider when they're looking at that?

Ben Barber: It's an interesting point, Stephen, when you think about, you know, both sides of the income statement. As Jen just alluded to, revenues were certainly hit hard. But you know, clearly with a lot of help from the federal government, you know, the revenue side of things has been much better than what we all thought nine months ago, 12 months ago. On the expense side of things, you know, it's important to remember rates are really at all-time lows. And so, accessing the municipal market was very cost-effective whether, you know, to deficit finance or to refinance debt service for the next couple of years as we recover. The other interesting point of this is just thinking about overall capital market access. Jen mentioned the MLF, the Municipal Liquidity Facility, that was, you know, really a great source of last resort-type of borrowing for many, many issuers across the municipal market. Only two of them ended up utilizing it. So, it just wasn't necessary at the end of the day, capital market access was actually quite, quite strong, you know, over the course of the year for municipal issuers overall.

Stephen Dover: Going back to the stimulus package and the provision that will not allow states to raise taxes. If I recall correctly, is part of the stimulus package, how does that affect the municipal area?

Jennifer Johnston: So, I think it's going to vary immensely by credit, depending on sort of where the strength is, how strong are you, how are you performing, and sort of how your tax structure works. Taxes are structured differently depending on the level of government you are. So I think I'm answering this in a very broad brush, meaning it's going to be dependent, and there's so much flexibility that is built into how states approach these things that I think the impact is not going to be significant.

Stephen Dover: Okay. Well, we just get off this stimulus package and we're already discussing a new, huge package in the infrastructure plan. So, maybe, Jennifer, you take a first shot at what do you expect with the infrastructure plan? Clearly, a lot of that's going to be financed by municipal bonds. What might the impact of that be?

Jennifer Johnston: Sure. So, I think there's two ways to approach that.

First, I think it's important to highlight that most of the infrastructure that's built in this country is built using municipal bonds. So clearly, it will be an important partnership with the state and local and transit entities as we move forward with any kind of bill. So we would expect to see additional projects, hopefully improved infrastructure and additional debt issuance as well.

The other thing I always like to mention about infrastructure bills, in particular, is that they're also often referred to as jobs bills because traditionally it's a lot of jobs that will be put in place to build whatever, you know, however the bill is ultimately targeted and that's good for economic stimulus as well. So in addition to improving infrastructure, we're seeing some more debt issued by municipal issuers, hopefully it's a boost to the economies as well and the communities seeing these projects.

Stephen Dover: So, Ben, the other part of this infrastructure plan is likely to be tax increases. I'm wondering if you could talk about tax changes, maybe income tax changes and how that might affect the market. There's some discussion that capital gains taxes would change, especially for higher income people. And then in past proposed legislation, there was some idea that there'd be some limit to the deductibility of interest on municipal bonds. I haven't heard that in this recent bill, but any thoughts on those three issues?

Ben Barber: Yeah, absolutely. I think the bottom line is with an increase in taxation that adds to the allure of munis, relative to other fixed income asset classes. Right? So, you know, we've known they're talking about an individual income tax hike, you know, for higher income portions of the economy. We know there's a corporate tax hike that is on the table. You know, the expansion of the estate tax, you know, possible capital gains tax. All of these taxation measures will serve to boost the relative value of munis versus other income asset classes.

So, I think the best way to think about it is, you know, we're pretty certain that tax increases are coming. We don't know exactly how much and who exactly will be impacted, but I think the overall impact will probably be positive for the relative value of munis. You know, we'll see how it goes, but I think the concept of sheltering, you know, income from taxation, you know, will certainly be a topic over the next couple of years. And, we view it as a positive for the relative value of munis.

Stephen Dover: So clearly, rising tax rates make municipal bonds relative to others a better investment. Do you think that's already in the municipal bond market, is it already priced in? Or do you think that that's something that perhaps is an opportunity for investors who think that tax rates are going to rise significantly?

Ben Barber: Yeah. I think some of the expectation is clearly priced in, but not all. And, I think we've seen this in lots of different, you know, cycles over time as taxation rates have changed, even going back to, you know, gosh, the mid-nineties. I think it was 1995 when Steve Forbes was running for President when he was, you know, really in the mix. And one of the big portions of his platform was thinking about the flat tax and muni valuations have changed at that time, while he was a, you know, a significant contender for the executive office while thinking about flat taxes. That, you know, obviously diminished the appeal or the potential appeal of munis back at that time. It takes a pretty significant move in taxation to truly move the needle for demand of munis.

And so, I think generally investors are best served by thinking about the overall theme of taxation. Is it going up? Is it going down? And you know, usually that will serve them the best. In terms of relative valuations over long periods of time, you know, munis tend to be very attractive on an after-tax risk adjusted basis versus other things in taxable fixed income. And so, it's only when you get to these extreme levels of valuations where munis are incredibly cheap or very, very rich, that, that starts to come into play. Over time, it generally tends to be, you know, very attractive to be a municipal bond investor if you're paying any sort of income taxes here in the US.

Stephen Dover: Jennifer, on that topic with all this stimulus, with an infrastructure plan coming, with states redeveloping, do you see any concerns about supply—there being too much supplier or perhaps in some cases, not enough? How do you see the supply over the course of the next year or so?

Jennifer Johnston: So, we saw a lot of refunding activity over the last six to eight months as we have already talked about. And when you focus a lot on that, that means you're not addressing your capital needs. So we do think that, you know, it's likely that now that everything is stabilized and we're going to have, especially if there's an infrastructure bill or other related, pieces of legislation at the federal level you're going to see it pick up. And, as a result, more bond issuance. Again, lower rates allow that to be a little bit more affordable. Assuming we get back to pre-pandemic levels, that was a very strong fiscal period of time. And, that was the time that you start investing in capital. So we'll see if we return back to those sort of financial levels, if that's what comes.

Stephen Dover: Jennifer, why is fundamental research so important in the municipal bond market?

Jennifer Johnston: Sure. So, just a little historical perspective, default rates for the muni bond sector as a whole are very low and lower than our corporate friends. And certainly was something that we were looking at closely throughout the pandemic and, you know, happy to report that, you know, while defaults have inched up and we've definitely seen downgrades. The amount of additional defaults as a result of the pandemic has been very low. And it's understanding, I think at the basics, how a sector works, what the laws are, and also how have sectors’ credits reacted in past cycles. Now, the pandemic is different than the great financial crisis as an example, but, you know, for analysts that have been following sectors since period of time, they understand the timing of recovery, they understand where those pressure points are. And so you just have to put it through a different lens, in terms of the pandemic, which is a different set of circumstances. And it allows us to go in and determine what kind of credits are going to be opportunities and maybe which ones you want to shy away from. And I think maybe a difference today as we address the pandemic, as opposed to past recessions has been the use of data. We've spent a lot of time really trying to leverage data, to help us get to answers more quickly and allow us to be more responsive, especially when unique opportunities appear in the market. As well as providing, again, a little bit of a more macro-overview of how sectors or states or regions are performing. And it's added a lot to our credit process.

Stephen Dover: That's interesting. I know that your team has really worked on a quantitative analysis in the muni bond area. I'm wondering, Jennifer, are there any particular sectors that you're concerned about right now or particular sectors that you think there's a lot of opportunity?

Jennifer Johnston: Sure. So, I would say that the opportunity is more within every sector, I think there's opportunities. I think, you know, in general, we've seen most sectors come through the pandemic fairly well. We had several sectors that really weren't largely impacted. Things like electric utilities, water utilities, you know, those sectors, you know, were still pretty strong throughout it. You still needed power and water or those types of things.

I think from a regional perspective, we're still, you know, cautiously looking at communities that have high tourism—their economy is highly based on tourism, you know, the uncertainty of when travel will actually come back. Many people, issuers as well as travel experts are saying, you know, travel really will not have fully rebounded until 2024, maybe even 2025. So, you know, communities there, you know, you want to take a real look at them. And of course, you know, areas that we're concerned about we would stay away from.

Stephen Dover: Thank you very much again, Jennifer and Ben.

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