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The municipal bond market took a wild ride in the first half of the year to near-historic levels of richness versus Treasuries that is rarely seen, and the environment is ripe for the second half of the year to take it even further. The outperformance of municipals in the first half can be attributed to many factors, such as inflation, rising tax rates and an imbalance of supply and demand. I believe these factors will continue in the second half setting up another favorable period for the municipal bond market.
According to Bloomberg market data, municipal bond yields have traded at approximately 100% of Treasury yields for the last two decades with two notable exceptions in late 2008 to early 2009 and then again in 2020, when long-term municipal bond yields traded significantly higher than long term treasury yields. The first half of 2021 saw municipal yields fall from approximately 90% of treasuries to 70% of treasuries which lead to municipal bonds outperforming treasuries by approximately 400 basis points. The Barclays U.S. Treasury index returned -3.44% versus Barclays municipal bond index return of 0.65%.
The main factor in the second half of the year that should help municipal performance is that the market is starved for supply. Demand has far outstripped supply so far this year, and I expect that to continue. Cash inflows into municipal bonds has been approximately $50 Billion in the first half with approximately $350 Billion in bonds being called or maturing. According to Ramirez and Co., the $350 Billion being called or maturing is more than the expected total tax-exempt issuance for the year of $331 Billion. Add in a very strong interest payment season during June, July, and August and I find it very difficult for the municipal bond market not to do well in the second half of the year.
The specter of higher tax rates and the continuation of people looking for any way to avoid higher taxes should continue to bolster the municipal market in the second half and add to the outperformance of municipals versus other taxable fixed income securities. There has also been talk in congress of reviving Build America Bonds, which are taxable and subsidized by the Federal government to pay for an infrastructure plan. BABs as they are known in the industry are taxable and would most likely decrease the issuance of tax-exempt bonds in favor of taxable municipals, leading to a more uneven demand/supply issue than we already have.
Inflation will continue to be a concern in the Treasury market as both input prices and output prices are increasing. The supply chain from chickens to computer chips is also a contributing factor with shortages being reported daily. Treasury yields will also fight a surge in issuance to cover the financing of trillions of dollars in relief packages, which should also weigh on Treasury yields for the rest of the year. The last piece of bad news for Treasury yields that should be mentioned is the potential of the Federal Reserve tapering its market purchases, pulling a strong level of support from the market. One positive I expect in the Treasury market is that I don’t expect the Federal Reserve to raise short term rates this year.
Municipals should be able to avoid the shortfalls seen in the Treasury market this second half as the demand seams unrelenting and the supply is very limited Even with the possibility of higher Treasury rates in the second half of 2021, investors are willing to accept lower tax-exempt rates If it means not having to give the government more money than they already do.
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Roberto Roffo is a Managing Director and Lead Portfolio Manager for SWBC Investment Company. He has extensive experience in managing many types of funds and strategies and over his career has been part of teams that have been responsible for raising over $50 Billion in tax-exempt and taxable fixed income assets.