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Unmasked Potential for Munis in 2021

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Unmasked Potential for Munis in 2021 Unmasked potential for munis in 2021 Our outlook for municipals this year BlackRock’s municipal bond experts share their market outlook and the actions you can take to raise your portfolio’s potential in 2021. Peter Hayes, Head of the Municipal Bonds Group Sean Carney, Head of Municipal Strategy The assets that command demand 138% of its outflows from the March selloff, while the Even as the pandemic spurred the most abrupt and severe high yield sector regained only 37%. In our view, high selloff of modern history, the S&P Municipal Bond Index yield is poised to readily outperform investment grade. finished 2020 with a gain of 4.95% as strong demand for Nevertheless, investors need to be highly selective as the muni bonds broadly outpaced supply. We expect the impact of the pandemic varies across market segments positive momentum to continue in the coming year, albeit and issuers. with moderated returns. Demand for munis has remained durable Municipal bond mutual funds have attracted positive Net flows into municipal bond mutual funds flows from investors in each of the past seven years — 100 since the extreme rate volatility infamously known as the “Taper Tantrum” stressed fixed income assets broadly in 80 2013. Demand for municipal bonds continues to be supported by highly accommodative monetary policy, while the potential for higher taxes under the new political 60 regime underscores the appeal of tax-advantaged investments. Notching a solid return for a tumultuous 40 2020 also bodes well for munis in the months ahead as positive returns tend to create further demand. 20 Billion Some volatility in fund flows can be expected given the 0 forecast for low- to mid-single-digit returns and the likelihood of interest rates moving modestly higher and -20 creating a steeper yield curve. Nevertheless, we anticipate another year of net positive flows into the asset class. -40 We view high yield municipals as a particularly appealing area to look for opportunities in 2021. The sector has -60 lagged in the broader muni rebound from the pandemic- ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17 ‘18 ‘19 ‘20 induced selloff, suggesting the potential existence of underpriced assets and room to move higher. By the end Source: Investment Company Institute, as of 12/31/2020. of 2020, investment grade municipals had recouped Past performance is no guarantee of future results. The index returns are shown for illustrative purposes only. It is not possible to invest directly in an index. January 2021 | Municipal market outlook USRRMH0121U/S-1480478-1/4 Municipals have provided consistent income over time Composition of annual total return 15 10 5 0 nnual return -5 -10 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 ● Coupon return ● Price return Source: BlackRock, above data reflects annual returns on the Bloomberg Barclays Municipal Bond Index, as of 12/31/20. Supply remains robust but more diverse a reduced amount of tax-exempt issuance, further strengthening the positive technical environment for Supply is likely to remain elevated this year albeit not to tax-exempt municipals. the extent believed prior to the Georgia runoff elections. Historically low interest rates create a favorable We expect another year of net-negative issuance in the environment for issuing debt. We anticipate annual tax-exempt space (i.e., when the total amount of debt issuance in the range of $450-475 billion, albeit with that is called, refunded or reaches maturity exceeds the periods of volatility, and continued strong demand to amount of newly issued debt). This tailwind has occurred absorb it. (Demand creates supply in credit markets.) more frequently in recent years versus the seasonal trends that once provided some degree of predictability. More important than the amount of issuance, however, is its underlying composition. Taxable municipals, which had As a new and more centralized administration steps into historically represented a very small portion of total muni office, we anticipate a renewed focus on infrastructure. issuance, have become a meaningful contingent since the The impact on muni issuance is likely to be minimal, ability for issuers to advance refund their debt via tax- absent a significant subsidized program similar to the exempt issuance was eliminated as part of the tax reform Build America Bond program that rolled out in 2009. in 2017. The probability of the new administration restoring the advance refunding exemption will have a Strategy insights for a volatile 2021 large influence on the amount of taxable municipal debt Volatility is a central theme of our 2021 outlook given the issued this year; however, under current tax law, we project myriad of uncertainties around the spread of COVID, the taxable bonds constituting 30% of municipal issuance in success of rapidly developed vaccines, the timing of a fully 2021. The increasing amount of taxable issuance implies re-opened economy, and the effectiveness of government Elevated issuance with more taxable bonds, which stimulus. While interest rates are set to remain broadly low, supports tax-exempt technicals we expect a further increase when economic activity returns Composition of total annual municipal issuance to normal. Municipals tend to outperform Treasuries when rates rise, retaining the appeal of the asset class even for 500 investors holding the most skeptical views on yields. 400 0 Despite higher volatility in rates, flows and issuance, we expect demand for municipals to remain durable and 300 continue to outpace elevated supply in 2021. We anticipate low- to mid-single-digit returns for the asset class, with notable contributions from the high yield 200 Billion sector both in terms of income generation and outperformance versus investment grade. Security 100 selection will be paramount given increased performance disparity among market segments. 0 2011 2013 2015 2017 2019 2021* We begin 2021 with a neutral stance on duration (interest ● Taxexempt ● Taxable rate risk) and a “barbell” yield curve positioning, i.e., Source: SourceMedia, BlackRock, as of 12/31/2020. *BlackRock forecast. heavier exposure to short- and long-term bonds vs. 2 USRRMH0121U/S-1480478-2/4 intermediate terms. We hold an overweight to credit What’s trending in taxes. States in the mountain west sectors and particularly high yield. In anticipation of an and mid-south that benefit from low tax burdens and a economic restart, we favor travel-related areas that could highly educated labor force with the ability to work from benefit from pent-up demand. We also hold a preference home are well situated. Caution is warranted in high-tax for local communities with strong housing demand in states and their large cities that are vulnerable to Colorado, Florida, Virginia and North Carolina. corporate flight and outmigration if remote working becomes the new norm. At the local level, demand for We believe the municipal bond market will continue to offer homes in suburban areas is driving property values, and attractive opportunities in the year ahead, but if there’s one consequently, tax receipts higher, buoying the thing investors learned in 2020, it’s the importance of fundamental outlook for local governments and school prudent risk management, flexibility and expertise to districts. Pension funding levels remain problematic for a navigate an increasingly diverse and volatile marketplace. handful of municipal issuers, although in our view, this Credit views for 2021 concern does not have to be addressed in the near term, especially given the strong investment performance Budgets in recovery. The pandemic has taken its toll on across the capital markets. 2020 budgets for state and local governments. Lockdowns curtailed revenue collections while the High hopes for high yield. Despite dramatic expansion of social programs and the spike in underperformance last March and April when the S&P unemployment drove spending well above forecasts. Municipal High Yield Index dropped -11.2%, the high yield Whereas a resurgence of the virus and further lockdowns sector finished 2020 with a strong gain of 6.00%, besting are worrisome, there are plenty of reasons to believe 2021 the broader S&P Municipal Bond Index by 1.05%. We will be a year of recovery for U.S. public finance: the roll anticipate that high yield will outperform again in 2021 out of vaccines, an economic boost from pent-up demand, with the tailwinds of low rates, limited supply, improving the resiliency of sales and income taxes, strength in U.S. fundamentals, attractive credit spreads, and the reversal housing and equity markets, and very low borrowing rates. of flows alongside investors’ increased risk appetite. Additionally, we believe the new administration will be Credits with measurable cash flows such as tobacco, more supportive to state and local governments and COFINA (Puerto Rico sales tax bonds), corporates and willing to provide stimulus as necessary. established retirement community bonds should be favored. We believe there is significant value in the Puerto Bargains await. Continued downgrades in municipal Rico general obligation and electric power authority (aka ratings are anticipated. This typically drives credit spreads PREPA) bonds, which are expected to be restructured wider, creating prospects to buy solid credits that are this year. Conversely, careful diligence is required before poised to benefit from the recovery. Sharp rebounds are investing in segments deeply impacted by COVID such likely in travel destination cities, the airports that serve as long-term care facilities, small universities and highly them, and dedicated hotel tax bonds in those markets. speculative start-up projects. Overall, we remain Hospitals that are experiencing compressed margins constructive on high yield municipals for their coinciding with the pandemic will mend when their diversification benefits, high levels of income and the volumes shift back to normal. Likewise, most colleges and potential to be rewarded for superior security selection. student housing issuers are looking forward to the return of students this fall.
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