In 2021, municipal (“muni”) bonds have been a tough asset class to manage due to overwhelming demand and limited supply in the market. Fundamentally, there are a few reasons for these conditions, and we’ll take a look at some data points to bring the bigger picture into focus.
- Investor expectations of higher taxes have been a primary underlying force behind the surge of cash flowing into municipals. Asset allocation models for investors in a higher tax bracket have likely been adjusted to reflect a higher tax rate because mutual funds and ETFs (exchange-traded funds) in the municipal space are flush with new money.
- The stimulus bill signed in March pledged $350 billion for state and local governments, $170 billion for education and $20 billion for public transit. If we are looking at muni yields as a percentage of Treasury yields, the stimulus package seems to have assuaged many of the COVID-19-related credit concerns that were at the forefront throughout 2020. Muni prices have sustained the recent increase in treasury volatility extremely well pushing AAA muni/Treasury ratios to historic lows.
The two charts below compare the AAA Bloomberg 30-year muni valuation and 10-year Bloomberg muni valuation to the 30-year and 10-year Treasury rate respectively. In 2021, the average 30-year muni has yielded 76% of Treasury, and the average 10-year muni yield has been 64.4% of Treasury. If we extend this ratio back 20 years, the average 30-year was 103.9% of Treasury and the average 10-year was 95.44% of Treasury during that period, with outliers in the 2008 crash and at the start of the pandemic in March of last year. 
Source: Bloomberg | Past performance is not indicative of future results.
So, what is pushing these ratios to trade outside of their historical averages? The biggest underlying factor driving the market in the current environment seems to be the significant amount of cash that the muni mutual funds and ETFs need to put to work. The chart below shows the ICI (Investment Company Institute) average weekly inflows into long-term municipal bonds and ETFs. The average weekly inflow for 2021 has been $2.3 billion of new money coming in per week. ICI’s data goes back to 2012, and over that time the average weekly inflows into long-term funds were closer to $528 million, with outliers to the downside in June 2013 and last March.
Source: Bloomberg
We believe that ETF growth, specifically, is worth looking at because cash inflows into ETFs have averaged $335 million per week making up about 15% of the average weekly inflows into muni funds in 2021. The growth of municipal ETFs over the past year has been significant even compared to the growing ETF market overall. The one-year growth rates for muni ETFs are more than three times the growth of the overall ETF market. The first graph below shows weekly inflows into muni ETFs and the second graph shows the size growth percentages of muni ETFs compared with a few other markets.
Source: Bloomberg Intelligence | Past performance is not indicative of future results.
With the increased amounts of cash coming into the market and cost of financing extremely inexpensive for municipalities, we expected more deals this year to meet increased demand. So far in 2021, that has not been the case. The Bond Buyer keeps an index of U.S. 30-day visible supply for municipal bonds and the average 30-day supply in 2021 has been $9.93 billion. Extending the data back 20 years, the average 30-day supply since 2001 has been $9.75 billion, so the new issuance numbers have not been substantially different in 2021 than recent history.
Source: Bloomberg
Another supply metric we can look at is the net supply numbers this year. For our data set, the net supply is defined as redemptions and maturities subtracted from long- and short-term new issue municipal supply. In 2021, we have had significant and consistent negative supply in the market without even considering the cash inflows to mutual funds and ETFs. As you can see in the chart below, net supply has been negative all year averaging -$7.79 billion reaching new lows of -$19.69 billion as of May 25. It is worth noting that June, historically, is always a huge month for redemptions and maturities and the net supply drops significantly every year around this time. This year, however, the June redemption money will be met with competition from the increased fund flows.
Source: Bloomberg Intelligence
As it stands, we have high levels of demand with limited amounts of supply resulting in strong price levels and good liquidity, but where does the muni market go from here? The biggest factors that the market is looking to dictate muni prices for the rest of the year are legislative changes and the inflation rate. There are infrastructure and tax changes currently being discussed and the government has not shown any hesitation with stimulus spending. Tax and spending changes will directly affect demand for municipal bonds. Additionally, the year-over-year CPI (Consumer Price Index) number was recently at the highest level since 2008, and the Federal Reserve will eventually have to respond to increased levels of inflation. The two most recent AAM Viewpoints articles discuss these two areas in depth and are worth a read. Jonathan Law discusses potential legislative changes in depth in his writeup LIFE’S CERTAINTIES: DEATH, TAXES…AND MUNICIPAL BONDS? and Matt Lloyd discusses inflationary pressures in THE FOUR LAYERS OF INFLATION. As we learned by the fund flow numbers, tax exemption is certainly a valuable aspect of investor portfolios, and these were some of the numbers we follow as traders to figure out what is motivating ebbs and flows in the market.
CRN: 2021-0601-9223 R
An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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