The muni market, beyond the headlines

December 9, 2020 | Vanguard Perspective

The muni market, beyond the headlines

Paul Malloy

Paul Malloy
Vanguard Head of Municipals

Nathan Will, Vanguard Head of Municipal Credit Research

Nathan Will
Vanguard Head of Municipal Credit Research

Key takeaways:

  • While headlines about state and local government finances appear to be negative, we believe the downside risks in the municipal bond market are overstated.
  • State and local government balance sheets were generally very strong heading into the COVID-19 pandemic, and decreases in tax revenue have so far been less severe than anticipated.
  • The municipal team at Vanguard—with its deep expertise and tenure over several market cycles—continues to be selective and opportunistic in its search for undervalued bonds.

Some investors may have read negative headlines about falling state and local government tax revenues. While revenues have generally decreased since the onset of the pandemic, issuers have responded quickly by using reserves, cutting expenses, and borrowing in the market in order to bridge these gaps while the economy recovers. As a result, stability has returned to the market, with municipal bond prices rebounding strongly amid robust demand.

Downgrades, but not defaults

Concerns about weaker issuers will persist in the high-yield space and the benefits from the path of economic recovery will transmit unevenly across sectors. But the story of the effects of the pandemic on municipal credit, particularly among investment-grade issuers, will read of downgrades and not defaults. We believe the municipal bond market—a crucial component of the funding mechanism for key infrastructure and services such as public education, health care, and transportation—will continue on its road of recovery.

Reasons for confidence

We see the majority of municipal issuers continuing to use all of the tools at their disposal to pay their debt service. Here’s why:

  • Although revenue shortfalls and budget gaps may initially sound daunting, state and local governments entered the pandemic in a relatively strong position. State reserves were at historical highs, and issuers have been applying lessons learned from the global financial crisis to provide them with the flexibility to meet their obligations until the economy recovers.
  • Preliminary reporting across several states and cities indicates that tax revenues did not drop as much as initially anticipated and are already recovering, which means that the size of gaps may be smaller than projected. For example, the October revenue report from California’s controller shows that through the first four months of the fiscal year (which ends June 30, 2021), tax revenues have remained strong, outpacing state estimates by approximately 24% ($10.4 billion). When annualized, revenues could potentially beat the budget by a significant margin. Similarly, the monthly reports from the New York State Department of Budget and Finance show that tax revenues in the Empire State, although lower than fiscal year 2020, have significantly improved each month since July. In November, State Budget Director Robert Mujica estimated the state’s cash balance will finish the fiscal year next June at approximately $4.2 billion.
  • We expect a fiscal relief package will be delivered in the first quarter of 2021. Even a modest federal aid package to state and local governments—in the range of $150 billion—would go a long way toward balancing budgets and restoring service cuts. A $500 billion package would mean services would get back to normal quickly.

How active management adds value

Our municipal team at Vanguard—with its deep expertise and tenure over several market cycles—remains selective and opportunistic. We add value through our ability to analyze sectors and individual issuers in the market, while taking potential downgrades and fiscal effects into account. We look to add bonds at favorable prices from issuers with strong long-term prospects for recovery.

For example, one sector where we see opportunity for our active funds is in toll roads, which have generally weathered the pandemic well because of ample liquidity, yet sold off as a result of fears of traffic decreases. According to Moody’s Investors Service, toll road authorities had enough cash on hand to cover a median of 900 days of expenses in fiscal year 2019.

In addition, commercial traffic, which typically pays higher tolls than passenger traffic, has performed very well throughout the pandemic and, in some regions, has already fully rebounded. Passenger traffic has rebounded from the lows experienced in April and is now down only about 20% year-over-year. The sector should continue to perform well even though traffic is not expected to recover to pre-COVID levels until 2023.

Focusing on fundamentals

In the coming months, as President-elect Joe Biden prepares to take office, there will be renewed calls for additional federal aid, along with the potential for more negative headlines. The political process is a noisy one, but our team, supporting our national and state tax-exempt funds, will continue to go beyond the headlines and short-term volatility and focus instead on long-term credit fundamentals.

For us, the bottom line is: Despite the recent volatility, municipals remain a high-quality asset class that offers attractive tax-exempt income with the opportunity for vigilant active managers to capture mispriced bonds and add value for clients.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
  • Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
  • The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about his/her individual situation before investing in any fund or ETF.