Rising Valuations May Reflect Improved Credit Conditions


  • The municipal credit backdrop is better than many expected and will likely remain strong into 2022.
  • Market strength is largely priced into high quality, tax-advantaged municipal bonds, which feature generationally low yields and rich valuations relative to corporate bonds and U.S. Treasuries.
  • High yield municipals outperformed their investment-grade counterparts in the first nine months of 2021, with spreads narrowing closer to what we consider fair value.
  • Puerto Rico’s exit from bankruptcy offers potential long-term opportunity for tax-sensitive investors.

Retail demand for municipal bonds continued to surge in the third quarter, following a solid first half. The credit backdrop has vastly improved – and with it, retail demand – aided by the U.S. Federal Reserve’s (Fed) broad array of actions to support the economy, including direct help for state and local governments. Expectations for higher tax rates in 2022 are also adding to investor confidence. Consequently, municipal bonds have performed better than expected, and we believe demand will remain strong into 2022. Much of the good news, however, is already baked into valuations, with high quality municipals featuring generationally low yields and rich valuations relative to taxable corporates and U.S. Treasuries.

Credit conditions on the mend but recovery has been uneven

Robust monetary and fiscal support has led to a faster-than-expected recovery from the COVID-19 pandemic for many states and local governments, and the credit cycle has largely turned positive.

Among the indicators of improved credit conditions:

  • Municipal credit rating upgrades have outpaced downgrades throughout much of the year.Footnotei
  • California – the largest issuer of municipal bonds – has turned a $54 billion shortfall for fiscal year 2021 into a $76 billion budget surplus for fiscal year 2022.
  • Following record-setting tax collections in March and April, New Jersey’s revenues are projected to hit all-time highs in fiscal year 2022, with the state now projecting a $10 billion budget surplus for the year – a nearly $4 billion improvement from February estimates.
  • Illinois received two of its first bond rating upgrades in 25 years.
  • House price appreciation is supporting local credit that depends primarily on property tax collections. Footnoteii