2021 Was a Good Year for Munis. Valuations Remain a Headwind

The municipal market has been a relative bright spot for core fixed income investors in 2021. While most of the other “safe” parts of the core fixed income universe have generated negative returns this year, the national muni market is up for the year (through December 22). With state and local governments flush with cash due to better-than-expected tax receipts along with generous amounts of federal aid, many municipalities are in good shape. The fundamental picture for many state and local entities improved rather significantly during 2021. Coming out of the COVID-19 economic shutdowns, many states and local governments were concerned that tax receipts would fall significantly. And while the initial impact of restrictions was indeed deleterious, state and local tax receipts have rebounded meaningfully since. Tax revenues are up 17% versus 2020 and 14% above the pre-pandemic period in 2019. Additionally, as the economy recovers, state and local tax receipts should remain supportive of budgetary priorities.

“2021 has been a good year for munis and valuations reflect that good story,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Continued positive inflows to the asset class along with the improved fundamental story for many state and local governments should provide a positive backdrop for returns next year.

However, the effects of higher tax collections, strong federal support, and robust investor demand has thus far had a positive impact on municipal bond valuations. As such, as seen in the LPL Research Chart of the Day, when looking at the ratio between AAA munis and similar-maturity Treasury yields, a common valuation metric, prices remain elevated at this point. And while the relative valuation story has improved in recent months, munis remain expensive relative to history with 10-year AAA and 30-year AAA munis near the bottom decile of historical valuations, meaning munis have been cheaper approximately 90% of the time. That said, while valuations, per se, aren’t necessarily a reason for yields and spreads to move higher in the near term, they do likely provide a slight headwind to potential future returns. As such, investor expectations should likely be guided downward as outsized returns are, in our view, unlikely.

As 2022 approaches, we continue to favor municipal bonds as a high-quality option for taxable accounts. Federal stimulus is providing support, although valuations relative to Treasuries remain elevated and demand may not get a boost from personal tax rate increases.

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