As markets continue to respond to an uncertain macroeconomic environment, the current fundamentals in the municipal bond market are creating an investment opportunity to capture strong after-tax total returns according to Stephen Dover, Head of Franklin Templeton Institute.
The Institute gathered Jennifer Johnston, Director of Municipal Bond Research, Franklin Templeton and Robert E. Amodeo, CFA, Head of Municipals, Western Asset Management, to discuss opportunities and concerns across municipal bonds.
Below are my key takeaways from our discussion:
Municipal bonds are displaying unusually strong fundamentals. The backdrop of local fiscal conditions is solid, contributing to the strength of muni bonds in the current environment. State and local governments have been able to replenish cash reserves as a result of three things: large capital inflows from the Federal level throughout the pandemic, tax receipts that have exceeded pre-pandemic levels and moderate spending. There has been less municipal bond issuance compared to the pre-pandemic period, creating a scarcity of muni bonds.
Some unexpected areas are creating headwinds for muni bond valuations:
- Commercial real estate. The shift to more remote work has impacted the office space sector and the businesses that support office spaces in downtown areas. This has led to lower assessed valuations, producing less property taxes. It is also felt in less transit use and funding. Other businesses in office areas may close, thus reducing tax revenues.
- Labor market. The strong labor market is a headwind in muni markets as it has created difficulty for states and municipalities to hire. Specifically, it has been difficult to hire nurses in health care and senior living settings, causing those organizations to rely on more expensive contract and travel nurses. It has also been difficult to hire some government administration roles with shortages of auditors leading to delayed financial reporting in some states.
- Inflation. Rising costs eat into operating costs and margins. On the capital side, costs increases are making projects and project financing more expensive. There is some benefit that comes from inflation for municipalities—as goods, sale prices and wages increase, so do the tax revenues for the locality.