Municipals outperform, but inflation risk stalls rally

Putnam Investments, 04/21/21


Q1 2021 Putnam Muni Bond Funds Q&A

  • Municipal bonds outperform the broader taxable market for the quarter.
  • Stabilizing credit fundamentals and favorable technicals helped counter inflation fears spurred by a faster-than-expected U.S. economic recovery.
  • We believe the lower tiers of the investment-grade universe and parts of the high-yield market offer attractive income and return opportunities.

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

The municipal bond market posted slightly negative performance for the quarter, with mixed month-to-month results. The quarter started off on positive footing, supported by favorable supply/demand technicals and an improving economic outlook. Investors were also in an upbeat mood due to the Biden administration’s plans to boost the Covid-19 vaccine rollout and to pass another stimulus package to spur economic growth.

After advancing in January, municipals reversed course in February, along with other interest rate-sensitive, fixed-income securities. The reversal was due to investor worries that additional stimulus measures would accelerate the economic recovery and lead to rising inflation. This resulted in higher bond yields further out on the yield curve while short-term interest rates remained near zero, anchored by the Federal Reserve’s monetary policy. The yield on the 10-year U.S. Treasury note rose from 0.93% on December 31, 2020, to a high of 1.74% on March 19, 2021 — a level not seen since January 2020 — and closed the quarter at 1.73%. The sharpness of the rise in bond yields in such a relatively short period of time unsettled the financial markets. Underscoring inflation fears, oil prices spiked to their highest in more than a year on March 15, 2021. The recovery in oil prices was due in large part to production cuts by oil-producing nations to draw down excess fuel inventories and to rising U.S. fuel demand.

Municipals regained their footing in March, with President Biden’s signing of the $1.9 trillion American Rescue Plan. This Covid-19-relief bill included another round of stimulus checks and $350 billion in aid to local and state governments. Later in the month, with inflation concerns still on the minds of investors, the Fed downplayed the possibility that it would reduce its support for the economy any time soon. Fed officials also revised their economic outlook for stronger growth for 2021 and affirmed that they still expected to keep interest rates near zero until 2023.

For the three months ended March 31, 2021, the Bloomberg Barclays Municipal Bond Index returned –0.35%, outper-forming the broader U.S. fixed-income markets. The Bloomberg Barclays U.S. Aggregate Bond Index and the ICE BofA U.S. 3-Month Treasury Bill Index returned –3.37% and 0.33%, respectively, for the quarter. Revenue bonds outper-formed general obligation bonds [GOs]. Within revenue-based bonds, the top-performing sectors for the quarter were hospitals, transportation, and leased-back bonds, while electric and water/sewer were the biggest underperformers. On the credit spectrum, higher-yielding, lower-rated municipal bonds outpaced higher-rated municipal bonds for the quarter.

What contributed to the improving municipal fundamentals and favorable technicals?

Credit fundamentals continue to stabilize, in our view. We’ve seen an uptick in state and local tax revenue from second-quarter 2020 crisis levels, although states with income taxes have navigated the pandemic better than states that rely more on sales taxes. States with popular leisure destinations, like Nevada and Florida, have felt the economic pain more acutely as mobility restrictions were implemented. Despite pandemic-related challenges, defaults remain low and within long-term ranges. In 2020, the default rate represented less than 0.25% of the overall municipal bond market, with defaults within the investment-grade-rated universe a rare occurrence.

With the outlook and confidence generally improving, technicals are favorable as well. Tax-exempt supply was relatively steady on a year-over-year basis and was met by very strong demand. Fund flows, a measure of investor demand for mutual funds totaled $31 billion for the quarter. The Biden administration’s proposed infrastructure plan, which includes increased taxes for corporations, could generate additional interest in tax-free municipal bonds. As such, we believe the technical backdrop is favorable for the asset class and should continue to be a tailwind for the balance of 2021.

How were the funds positioned in this environment?

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. With regard to credit quality, we believe the lower tiers of the investment-grade universe [BBB-rated securities] and some parts of the high-yield market offer attractive income and return opportunities. Duration positioning, a measure of the funds’ interest-rate sensitivity, was generally neutral relative to the level of their Lipper peer groups at quarter-end. For our longer-term state and national municipal bond funds, yield-curve positioning was defined by an overweight in bonds with maturities of 10 to 20 years relative to their respective Lipper peer groups at quarter-end. As part of this strategy, the funds generally held an underweight exposure to long maturity holdings compared with the Lipper peer groups.

The funds also 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 profile continues to stabilize and that its 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 PR 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 outlook for the coming months?

Municipal bonds have withstood a lot of market volatility since March 11, 2020, when the World Health Organization announced the coronavirus outbreak had reached the level of a pandemic. Just over a year later, we believe we are coming out on the other side of this health crisis, with the aid of multiple relief packages and medical advancements. The recent cash infusions provided by the American Rescue Plan will help state and local governments enter their 2022 budget sessions with enough cash on hand to help absorb the economic stress of the pandemic, in our view.

In addition, we believe that with the easing of mobility restrictions and the American Rescue Plan, U.S. economic growth will be strong in 2021. At the same time, the Fed remains committed to its twin goals of maximum unemployment and 2% sustained inflation. With these and other factors at play, we believe the greatest opportunities reside in the lower parts of the investment-grade universe as well as the high-yield sectors at this point in the economic recovery.

We’ll continue to adjust the portfolio to reflect the team’s best ideas to secure income as well as total return prospects in this evolving interest-rate environment.