Last year’s municipal bond market volatility was unprecedented, with muni outflows hitting record levels in March of 2020. However, munis have enjoyed a tremendous rebound over the last 12 months. Year to date inflows into muni bonds have totaled roughly $40.0 billion.1 This figure is large enough to make 2021 the fourth highest year of inflows since 1992, when Lipper first started tracking flow data.2
At the same time, the bellwether 10-year AAA municipal/treasury ratio is around 60%. This ratio, a signal for muni valuations, currently reflects an expensive muni market. In fact, the ratio has not been this low since the mid-1980s, a time when U.S. individual income tax rates topped out at an astonishing 50%.3
Based on this year’s significant inflows and the AAA municipal-to-treasury yield ratio, high grade municipal bond valuations certainly look rich by historical standards. Should this be cause for concern? Let’s first look at the two major factors driving demand.
1. Investor optimism
As vaccinations have been distributed across the U.S. and a light at the end of the tunnel is in sight, prospects for economic recovery have improved and investors have shifted to a new risk-on mentality. This renewed optimism has carried over to the muni market, aided by higher-than-anticipated tax revenue collection. For example, California saw total tax collections of $162.6 million for the 12-month period ended March 31, 2021. This represents a 7.6% increase over collections of $151.1 million over the 12-month period one year prior.4 Recent stimulus in the amount $350 billion also left some issuers across the U.S. with surplus funds. As a result, credit rating agencies have recently raised their outlooks from negative to stable on general obligation debt tied to some lower-rated state issuers.5
2. The likelihood of rising taxes
President Biden has proposed increasing several tax rates, including the top individual income rate, the corporate rate, and the capital gains rate, as a means to help fund social programs, infrastructure projects, and other government initiatives. Some state governments, such as New York, have already increased their top tax rates. Understanding the impact of these rate increases is key to breaking down current valuations and investor behavior. We believe that tax rates have had some influence on muni valuations and that rising tax rates make tax-exempt income more valuable for individual investors as well as some institutions.
Tax Increases and Muni Valuations
To better understand the impact of a rising tax rate environment, it’s important to consider history. Over the last 30 years, the top U.S. federal income tax rate for individuals has risen and fallen (Figure 1), with the 1990s beginning with a top tax rate of 28% before surging to 39.6% in 1993. This remained the highest rate until President George W. Bush cut taxes in 2001 and again in 2003. The current top income rate is 37%.
The value of tax-exempt income in a high tax environment is underscored by the changes in the AAA municipal/treasury ratios over time. These ratios remained relatively rich (by modern standards) when tax rates were higher, averaging 78% between March 1991 to December 1999, according to Bloomberg (Figure 2). Ratios became cheaper in the 2000s and 2010s when tax rates trended downward. During these decades, ratios averaged 90% and 96%, respectively, suggesting that investors shifted out of municipal bonds when the tax benefit was less advantageous.
However, this trend began to reverse in 2019, well before the inception (or even the idea) of the Biden Administration. Ratios were already nearing their pre-2000 averages as early as the second quarter of that year. As discussed by Matthew Gastall from Morgan Stanley in his April 2019 monthly report, the then recently installed SALT deduction cap raised net tax rates for some investors, which in turn drove higher demand for tax free income.6 Ratios more or less held their ground in the following months until the global pandemic proceeded to distort them for the better part of 2020.
Fast forward to April 2021. With the Biden tax proposal and some states already increasing taxes, many forecasters are assuming tax increases will happen at both the state and federal levels. President Biden has proposed hiking the top individual tax rate from the current 37% to 39.6%,7 and according to the Wall Street Journal, New York’s recently passed legislation will also increase taxes on the state’s highest earners.8
The bottom line is that tax-exempt income may become more valuable as tax rates go up. This means that in the current environment munis could persistently trade at high valuations, based on AAA municipal/treasury ratios.
Figure 1: The top tax rate soared in the 1990s...
U.S. Individual Income Tax: Tax Rates for Highest Tax Bracket 1990-2021
Source: U.S. Department of the Treasury. Internal Revenue Service, U.S Individual Income Tax: Tax Rates for Regular Tax: Highest Bracket [IITTRHB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IITTRHB, April 29, 2021.
Figure 2: …and muni valuations were persistently rich, relative to modern times.
10-Year AAA Municipal/Treasury Ratio March 1991-April 2021
Source: SIFMA as of 4/22/21.
Holding Period Matters
Regardless of valuation, history demonstrates that, over time, municipal bonds have proven to be highly resilient. It’s this resiliency that underscores the importance of investors not getting caught up in trying to time the muni market. Attempting to tactically buy or sell municipal bonds doesn’t necessarily protect investors from losses and could potentially limit total returns over time.
To confirm this remains true in the current environment, we looked at rolling performance over the 10-year period between March 31, 2011 and March 31, 2021, measuring the historical total returns for a hypothetical portfolio consisting of 75% investment grade municipal bonds and 25% below investment grade municipal bonds (Figure 4).
Figure 4: Holding period matters. Median total returns increased incrementally, with each increase in holding period
Source: Morningstar. Measures the performance of a hypothetical portfolio consisting of 75% investment grade municipal bonds (represented by Bloomberg Barclays Municipal Index) and 25% below investment grade municipal bonds (represented by Bloomberg Barclays High Yield Municipal Index) during rolling periods from 3/31/2011 – 3/31/2021. Total returns are not annualized. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. For illustrative and discussion purposes only. Hypothetical portfolio does not represent actual Client accounts or actual trades and may not reflect the effect of material economic and market factors. The actual transaction costs and other data in Client accounts may be different and performance will vary. This illustration is not a prediction of future performance and should not be relied on to make investment decisions.
We found that when the hypothetical municipal bond portfolio was held for 18 months or more, total returns were positive across all rolling periods. In fact, the length of the holding period mattered, as indicated by the median return and worst-case return columns in the table. With each step-up in holding time, total return potential increased incrementally while the worst case return improved incrementally. Moreover, we ran U.S. Treasury bonds through the same test and found that a dedicated hypothetical portfolio of 100% U.S. Treasury bonds fared worse than municipals. Treasuries generated at least one negative rolling return period all the way up through 24 months of holding time.
These results are evidence of the benefits of holding municipal bonds for the long-term and demonstrate how attempting to time a tactical allocation in this asset class can lead to poorer outcomes for investors.
Regardless of current relative valuations, municipal bonds should continue to be an important part of a diversified, long-term asset allocation. Our perspective remains that a strategic allocation to municipal bonds can also be enhanced via the benefits of active management. In the current low yield environment, we believe that active managers who are able to take advantage of price weaknesses and market dislocations are well-positioned to add significant outperformance over passive approaches.
1. Source: Lipper, J.P. Morgan as of 4/21/21.
2. Source: Lipper, J.P. Morgan as of 4/21/21.
3. Source: The Bond Buyer, “Funds on fire as muni/UST ratios fall to 1980s-level lows”, February 4, 2021.
4. Source: J.P. Morgan, 4/16/21.
5. Source: Citi, 4/12/21.
6. Source: Morgan Stanley WM Municipal Research, “Brand New Day” 4/24/19.
7. Source: Wall Street Journal, “How Biden’s Tax Plan Would Affect Investors” https://www.wsj.com/articles/how-bidens-tax-plan-would-affect-investors-11619694009
8. Source: Wall Street Journal, “New York State’s Tax Increase: What High Earners Need to Know” https://www.wsj.com/articles/new-york-states-tax-increase-what-high-earners-need-to-know-11617886887
This material represents an assessment of the market environment as at a specific date, is subject to change and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances, and consideration should be given to talking to a financial advisor before making an investment decision.
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