Municipals hold steady amid inflation and Covid concerns

Q4 2021 Putnam Muni Bond Funds Q&A

  • Continued improvement in credit fundamentals and strong demand helped the asset class notch a small gain for the quarter.
  • We view lower-rated investment-grade securities and portions of the high-yield market favorably but believe that 2022 returns are unlikely to match those in 2021.
  • We believe the Fed will complete its asset-purchase tapering by March 2022 and begin raising short-term interest rates shortly afterward.

How did municipal bonds perform during the fourth quarter of 2021?

Municipal bonds performed relatively well amid mixed economic data, rising inflation, and fears that a surge in Covid cases might lead to renewed pandemic restrictions. Continued improvement in credit fundamentals and strong demand helped offset the performance-dampening effects of those concerns. The Bloomberg Municipal Bond Index rose 0.72%, outperforming U.S. Treasuries [0.01%] and the broader U.S. fixed-income markets [–0.01%] for the quarter.

Solid municipal credit fundamentals were supported by a strong economic backdrop and sizable fiscal aid. State and local tax collections remain very strong, climbing 14% in the first half of 2021 year over year. Additionally, a Pew Charitable Trusts report found state pensions are in their best condition in 13 years. The American Rescue Plan, which provided $350 billion in aid to state and local governments in the spring of 2021, coupled with a strong rebound in the U.S. economy, has allowed state budgets to outperform forecasts. Last, the Infrastructure Investment and Jobs Act, signed into law in November 2021, will likely be positive for many municipal borrowers. Federal grants for these projects should reduce the need for municipal borrowers to issue debt to cover essential services such as repairing roads and bridges, funding new broadband and climate initiatives, and modernizing the power grid. This could increase fiscal flexibility for these borrowers while avoiding higher tax burdens.

Investor demand for municipals remained strong during the quarter, helping to support their prices in the rising interest-rate environment. This was due to U.S. Treasury yields sitting at historically low levels, which pushed investors to seek alternative income opportunities. The pace of inflows into municipal bond mutual funds increased considerably as a result. Given the heightened demand, 2021 was the largest inflow year on record, according to Lipper. Supply has been consistent with that of 2020. However, the composition of supply is a bit different, with more tax-exempt issuance coming to market than taxable issuance. We believe this was due to the tax policy uncertainty in Washington, D.C. in the second half of 2021.

After months of increasingly hawkish communications, the Federal Reserve announced that it would begin reducing its monthly bond purchases of U.S. Treasuries and mortgage-backed securities in November 2021. Minutes from the Fed’s meeting in December 2021 acknowledged that an environment of strong growth and high inflation combined with the Fed’s larger balance sheet holding down longer-term borrowing costs could lead to a faster pace of policy rate normalization. Investors interpreted those comments as suggesting the Fed could begin raising rates as early as the spring of 2022 to moderate inflation.

How were the funds positioned in this environment?

At quarter-end, the funds held an overweight exposure to investment-grade bonds rated A and BBB relative to the benchmark. The funds also held an overweight exposure to BB-rated bonds relative to their respective Lipper peer groups. From a sector- or industry-positioning perspective, we favored continuing-care retirement communities, private higher education, and charter school bonds relative to the funds’ Lipper peer groups. Duration positioning, a measure of the funds’ interest-rate sensitivity, was generally neutral relative to the level of their respective Lipper peer groups at period-end. The funds generally held an underweight exposure to the longest-maturity bonds compared with the benchmark.

Regarding our strategy for state debt, the funds held an overweight exposure to Illinois relative to their Lipper peer groups. We believe Illinois’s financial profile continues to stabilize, and its flexibility and credit fundamentals have improved since the onset of the Covid pandemic in the United States. During the quarter, we trimmed the overweight position slightly as credit spreads tightened due to improving municipal credit fundamentals and strong market technicals. [Credit spreads are the difference in yield between higher- and lower-rated municipal bonds.]

We remain cautious about investing in bonds issued by Puerto Rico due to what we believe are its seemingly fragile economy, weak demographic trends, poor-quality infrastructure, volatile political environment, and history of fiscal mismanagement. As such, the funds remained underweight in their exposure to uninsured Puerto Rico municipal debt relative to their Lipper peer groups. We continue to monitor the Commonwealth’s ongoing restructuring efforts for potential opportunities.

What is your outlook as we enter the first quarter of 2022?

Given the current path of inflation and the course of the pandemic, we believe we are likely to see continued interest-rate volatility. The pandemic-related supply chain and labor market disruptions have been more persistent than we had initially expected, leading to delays and output shortages that could be with us for some time. The near-term result has been an elevated inflation backdrop that, in our view, will likely weigh on consumer sentiment and erode demand. The higher-than-expected inflation has caused the Fed to pivot to a more hawkish stance, prompting speculation that it will tighten monetary policy more quickly.

We believe the Fed will complete its asset-purchase tapering by March 2022 and begin raising short-term interest rates shortly afterward. In our view, inflation will moderate toward the Fed’s long-term goal of 2% in the second half of 2022. The combination of a tightening Fed and a strong economic backdrop leads us to an investment outlook for municipal bond index returns that will be similar to what we saw in calendar 2021. The most interest-rate-sensitive portions of the municipal bond market could underperform if our outlook is realized, while credit and shorter-duration assets could outperform, in our view. Our near-term outlook is for slower growth than previously expected.

Credit fundamentals remain strong, in our view, as tax revenues have sharply rebounded on the back of higher property values, a strengthening labor market, and increased economic activity. We expect credit fundamentals to remain positive going into calendar 2022, but note that valuations largely reflect the current reality. We still view lower-rated investment-grade securities and portions of the high-yield market favorably. However, we believe 2022 returns for securities rated BBB and below are unlikely to match those in 2021.