Municipals rally on stimulus and vaccine hopes

Putnam Investments, 01/25/21


Q4 2020 Putnam Muni Bond Funds Q&A

  • Municipal bonds outperformed U.S. Treasuries and the broader taxable market for the quarter.
  • The municipal bond market has experienced an increase in downgrades but remains sound overall, in our view.
  • We believe technicals are favorable for the asset class and should prove to be a tailwind into 2021.

How did municipal bonds perform during the fourth quarter of 2020?

Against a backdrop of stabilizing U.S. fundamentals and positive supply/demand technicals, the municipal bond market achieved its third successive quarterly gain. The Bloomberg Barclays Municipal Bond Index [the municipal benchmark] rose 1.82%, outperforming U.S. Treasuries and the broader U.S. fixed-income markets. November was an especially solid month, with the municipal benchmark climbing 1.51%. Announcements by Pfizer/BioNTech and Moderna regarding the efficacy of their vaccines and the formal start of a Biden transition boosted investor sentiment. Furthermore, with Congress working on another stimulus package, one that investors believed would include more aid to state and local governments, confidence in municipal bonds increased. The asset class closed 2020 with a gain of 5.21%.

As the fourth quarter progressed, however, a resurgence in cases of COVID-19 and renewed measures to contain the spread threatened the pace of economic improvement. Just days before quarter-end, Congress passed and President Trump signed a $2.3 trillion coronavirus stimulus and short-term spending package into law. However, aid to state and local governments did not make it into the coronavirus relief bill. President-elect Biden stated that he would pursue the funding in 2021.

In its final policy meeting of 2020, the Federal Reserve kept its key overnight interest rate near zero. The Fed also remained committed to its massive bond-buying program and to channeling cash into the financial markets. It indicated the measures would stay in place until its maximum employment and price stability goals were met. The central bank also revised its outlook for economic growth up to 4.2% and its outlook for the unemployment rate down to 5% for 2021. This helped to rally sentiment. However, some uncertainty returned as the year came to a close. The January 2021 U.S. Senate runoff election in Georgia and its implications for the balance of power in the U.S. Senate was one source. The emergence of a new variant of the coronavirus was another.

What factors contributed to munis' strong technicals?

With the outlook and confidence generally improving, fund flows, a measure of investor demand for mutual funds, were positive during the quarter. The prospect for higher taxes to meet budget shortfalls helped to sustain interest in the asset class, in our view. The relative value that municipal bonds offer was another factor. Additionally, we believe investors were drawn to municipal bonds for their historically low-default frequency and the diversification benefits they offer relative to other more volatile asset classes. Supply was very strong in October as municipal borrowers refinanced existing, higher-coupon debt, but supply then tapered off in November and December.

Despite the extreme volatility created by the pandemic-induced sell-off and subsequent recovery, the municipal bond market finished 2020 much as it began from a technical perspective. Tax-exempt supply was relatively steady on a year-over-year basis and was met by solid demand. As such, we believe the technical backdrop is favorable for the asset class and should prove to be a tailwind into 2021.

How were the funds positioned in this environment?

With regard to credit positioning, we focused on lower-rated investment-grade bonds and select high-yield bonds. We believe the lower tiers of the investment-grade market, particularly those rated BBB, and parts of the high-yield universe represent some of the best income and return opportunities. However, we're extremely discriminating given the ongoing economic uncertainty. From a sector or industry positioning perspective, we favored long-term care, private higher education, land secured, charter schools, and transportation, as well as other revenue sectors relative to the funds' Lipper peer groups.

Duration positioning, a measure of the portfolios'/funds' interest-rate sensitivity, was generally neutral relative to the level of the Lipper peer groups at quarter-end. The funds' yield curve positioning was defined by an overweight in bonds with maturities of 10 to 20 years. As part of this strategy, the funds generally held an underweight exposure to long maturity holdings compared with the Lipper peer groups.

The funds held an overweight exposure to revenue bonds versus general obligation bonds. The funds' exposure to state and local governments was limited to those with, in our view, diverse tax bases and the ability to enact broad revenue enhancements or expense cuts. As part of our strategy for state debt, we held an overweight exposure to Illinois. We believe Illinois' financial flexibility and credit fundamentals were not completely reflected by market spreads.

The funds remained underweight in their exposure to uninsured Puerto Rico municipal debt compared with their Lipper peer groups. In the funds that held Puerto Rican debt, the exposure represented less than 0.5% of total net assets and was predominantly composed of pre-refunded bonds. We remain cautious on Puerto Rico due to its seemingly fragile economy, weak demographic trends, poor-quality infrastructure, volatile political environment, and history of fiscal mismanagement. We continue to monitor the Commonwealth's ongoing restructuring efforts for potential opportunities.

What is your current assessment of the health of the municipal bond market?

The sudden onset of the recession in March 2020 due to pandemic-related shutdowns and business closures was unparalleled. That said, many states entered this recession in their best fiscal shape in over a decade. Additionally, a major source of funding for local municipalities is property taxes, which are based on home values. Nationwide, home values climbed more than 6.6% year over year through December 2020, according to Zillow, a real-estate marketing company. This is a very different scenario from the 2008–2009 Great Recession, which had a negative impact on property values and, by extension, property taxes. Consequently, we believe most states have ample re-serves to address a decline in revenues. In our opinion, even states that were less well prepared still have quite a bit of financial flexibility and avenues to raise capital through the credit markets. So, while the municipal bond market has experienced an increase in downgrades, the asset class remains sound overall, in our view.

What is your outlook as 2021 begins?

Municipal bonds demonstrated resilience in 2020, faring better than many analysts anticipated. Credit spreads, while still wider than the pre-pandemic levels, significantly retraced from the extreme levels that occurred during the historic sell-off. And while we are seeing credit fundamentals broadly weakening, we still believe that defaults will remain low.

In our view, the municipal bond market is poised for continued recovery in 2021, with the greatest opportunities in the lower parts of the investment-grade universe as well as the high-yield sectors. As always, we will continue to balance the pursuit of tax-free income with prudent risk management as we search for the most attractive opportunities in the tax-exempt bond market.