As advisors often see, high-income investors love municipal bonds. And for the most part we’ve shared that love. Tax-favored income and low correlation to equities, what’s not to love?
But it seems investors are piling in with little regard for price, even with tax-equivalent yields lower than their Treasury counterparts. The rich pricing can likely be attributed to a limited supply of bonds as state and local governments have received significant government funding on top of record tax inflows from increasing property values.
And we’re not alone; Bloomberg’s Muni Bonds Are the King of Costly cites the raging inflows and extreme muni-Treasury ratios as danger signs. One chart from that piece below:
Source: Bloomberg (as of 2/22/21)
Simply put, these groups are flush with cash with even more stimulus on the horizon as Biden’s $1.9bn stimulus plan is substantially front-loaded. As new issuance has temporarily decreased, investors are working with limited supply and in turn bidding up prices.
Projections via Strategas (As of 2/23/2021)
While we’ve generally encouraged high tax bracket investors to look to municipal bonds as anchor positions, the value prop from here looks limited. Even given the higher probability of higher tax rates for both individuals and corporations under a Democratic government, we’re no longer sure the math adds up and we expect spread to Treasuries to normalize.
Historically, the muni space has shaken investors with painful reversals when trends are overdone, as seen following the 2016 presidential election and after the Puerto Rico credit crisis in 2013. We’d tread carefully in municipals as this plays out.
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