Historically it has been unwise to attempt to “play” the stock market ahead of an election in an attempt to position based on perceived implications of a president’s policies, but the municipal bond market may be more susceptible to the results of this election. As stimulus talks in Washington appear stalled but not officially over, we outline the potential for investment opportunity in the municipal bond market going forward.
The municipal market had an eventful spring. As shown in the LPL Chart of the day, municipal bond yields relative to US Treasuries have contracted since that economic weakness in the spring, which severely hampered municipal budgets. Since the US economy has emerged from lockdown, much of the initial investment opportunity has been captured, but municipal yields still provide a relative yield advantage to Treasuries—tax advantages aside—as this ratio has held steady over 100% as of October 23, indicating a higher yield for similar maturity municipal bonds.
If the Democratic Party wins the presidency and both chambers of Congress—a blue wave—it is likely that higher income and corporate taxes will be a policy priority. This could be positive for municipal bond demand, and may bring back many of the institutional players that may have lightened their exposure to the market following the tax changes from the Tax Cuts and Jobs Act of 2017. Current stimulus proposals from Congressional Democrats also have focused on aid to state and local governments, which may be a positive for the health of municipal financial conditions.
However, the treatment of state and local tax deductions under a Joe Biden presidency would remain a variable for retail demand, as well as state tax revenues. Netting these effects, we think municipal yields may rise, but we would expect them to outperform Treasuries.
If there is no blue wave, the potential for additional fiscal stimulus in the near term may be less and may require a deeper assessment of economic and unemployment conditions for consideration. If there is no additional stimulus, we may see an increase in supply through deficit funding, and muni/Treasury ratios may remain elevated.
“Overall, it would seem the outlook for the muni market depends more on the passage of additional stimulus—perhaps more so than the equity market—which may hinge on the results of the elections,” said LPL Chief Market Strategist Ryan Detrick. “Ultimately, we think there will be additional fiscal stimulus, but the timing of the stimulus remains quite uncertain.”
We expect interest rates to rise modestly in 2021, but we stop short of calling for a bear market for bonds. We continue to recommend slightly below benchmark interest rate risk, and maintain our preference for municipal bonds over richly valued Treasuries, even in the face of stimulus uncertainty.
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