After last year’s pandemic driven sell-off in March where muni yields and spreads spiked higher, the muni market looks very different today.
- The yields of the ten-year U.S. Treasury, after hitting a low of around 0.50% last year, is now around 1.70%. Meanwhile, the municipal 10-year AAA MMD is now above 1%.
- As yields rise, a greater number of municipal securities are being priced to a discount, the IRS’s de minimis tax rule may become a greater concern for investors.
- While investor demand for debt issued by borrowers and sectors hit hardest by the pandemic remain strong, we are mindful that this sentiment can shift rapidly.
Now, there is renewed optimism in the economy fueled by increased vaccination rates in the U.S., additional federal stimulus funding, and reopening of businesses shuttered during the pandemic.
However, market concerns about inflation are starting to take hold resulting in a recent spike in benchmark yields from record low levels.
Meanwhile credit spreads have declined back to pre-COVID levels. In this shifting landscape, we remain vigilant on how these dynamics play out in the current market environment and their impact on muni bond valuations.
As the market anticipates a rebound in economic growth, interest rates are starting to rise once again. After hitting an all-time low in the middle of last year, yields rose sharply in February.
The yields of the ten-year U.S. Treasury, after hitting a low of around 0.50% last year, is now around 1.70%. Meanwhile, the municipal 10-year AAA MMD is now above 1%.
Both benchmarks are now near pre-COVID levels. It remains to be seen whether this is a return to a more normal rate environment, or the onset of greater inflationary pressures for the future.
Figure 1. Treasury and AAA Muni Yields Moving Higher from Last Year’s Lows
As yields rise, we are observing a greater number of municipal securities being priced to a discount, especially for those recently issued at par with lower coupons.
As bond prices start to see a larger discount as yields rise, the IRS’s de minimis tax rule may become a greater concern for investors.
The rule determines whether the price appreciation of securities purchased at a discount will be taxed at the ordinary income or capital gains tax rate.
For securities with prices below the de minimis threshold, it may result in potentially higher taxes for a purchaser of that security.
Given the potential tax risk and interest rate sensitivity for lower coupon bonds, we continue to monitor market demand for this type of structure and its impact on bond valuations given the rising yield environment.
Despite the rise in interest rates, credit spreads continue to fall as municipal issuers have shown strong resiliency throughout the pandemic.
While some feared a wave of municipal defaults, rating downgrades, not defaults, were more widespread. Many of the defaults were isolated in COVID hit sectors – senior living, student housing, retail/commercial development, and start-up project finance issues.
For state governments, the financial impact has been more muted with tax revenues in 2020 down slightly, -0.4%, from the year before (Source: Urban Institute).
The latest round of federal stimulus funding includes $350 billion to aid state and local governments during the pandemic – further supporting municipal credit fundamentals. This is helping to drive credit spreads back to pre-COVID levels, even for the most impacted sectors.
Figure 2. BBB Spreads Continue to Decline, Now Approaching Pre-COVID Levels
For instance, NY MTAs, the largest mass transit system in the U.S., has been one of the hardest hit borrowers during the pandemic.
MTA credit spreads at one-point last year were over 350 basis points above the benchmark AAA. Spreads have now rallied back to around 90 basis points despite a still challenging backdrop.
Subway ridership remains down around 70% and, in the most recent February financial update, the system projected an $8 billion deficit over 2021-2024.
Regardless, the muni market is expecting this deficit to be largely offset with funds coming from the new federal aid package.
Figure 3. NY MTA Bonds Have Rallied Despite Subway Ridership Still Down Around 70%
In this changing landscape, we remain watchful of the cross currents of rising bond yields but tightening credit spreads and the subsequent impact on bond valuations.
While investor demand for debt issued by borrowers and sectors hit hardest by the pandemic remain strong, we are mindful that this sentiment can shift rapidly.
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