Rising Tide Lifts Municipal Bonds

No, your eyes do not deceive you. Municipal bonds have not only recovered, posting positive returns in Q4 of 2020, but they have also continued to generate positive returns through the first four months of this year.

We always look to fundamentals to explain the behavior of the muni bond market. The following elements are now—and we believe for the foreseeable future—supportive of investor commitment to the municipal asset class:

1. Weekly flow of $1 billion or more into municipal funds, ETFs and separately managed accounts: The demand-supply discussion is not new. While new issues will continue to be plentiful, the current rate environment now leads to a new-issue blend of taxable and tax-exempt bonds. This may diminish reinvestment opportunity for tax-exempt dollars, leading to a narrowing of spreads all along the yield curve and generating positive returns.
2. Government stimulus programs: Around 16 million people have been taken off the unemployment rolls. Stimulus programs have also funded critical deficits, including the State of Illinois and New York MTA, and provided an economic cushion to forestall the fears of widespread credit impairment at the state and local levels.
3. Vaccine coverage: The growing population of vaccinated people in the U.S. has laid the foundation for economic reopening and recovery, evidenced by the performance of the equity markets. State and local governments can now resume providing jobs and services to support economies.

While we expect discussions to continue around the direction of rates or the magnitude of change, we believe managing exposure within investment grade is clearly in play in 2021. The short and intermediate segments of the yield curve—such as the exposures provided by the VanEck Vectors^® Short Muni ETF (SMB^®) and VanEck Vectors^® Intermediate Muni ETF (ITM^®), respectively—may offer duration protection against moves to higher rates. In our view, investors can expect a modest performance of 3-5% (described as “earn the coupon”) to be the target for investment grade municipal bonds.

High yield municipal bonds, which investors can access through the VanEck Vectors^® High Yield Muni ETF (HYD^®) and VanEck Vectors^® Short High Yield Muni ETF (SHYD^®), also continue to benefit from the points made above. We believe they will be the beneficiary of a longer credit recovery path and, hence, stronger relative performance as income seekers continue to allocate to this space. A longer “tail” to the recovery of institutions under duress in Healthcare and Project Finance is expected, but the outlook has improved markedly from 6-9 months ago. The expected near-term beneficiaries of the recovery in muni high yield may encompass nearly 33% of HYD’s portfolio. We believe sectors such as transportation, special tax, lease-backed and housing already have and will continue to drive spread contraction and performance.

Finally, the reemergence of issuers from Puerto Rico’s myriad of defaults will play a large role in offering diversification and opportunity in high yield. Current index exposure to eligible Puerto Rico issuers is nearing 3.75% (COFINA sales tax backed bonds primarily). With negotiations nearing completion on the refinancing of bonds from several other large public entities, exposure may double. We believe demand for the new bonds from muni high yield funds and ETFs will give a boost to performance. We expect more clarity on this point in the coming weeks and months.