Separately Managed Accounts

Boston - With the results of the January 5 runoff elections in Georgia coming in, the Democrats appear poised to take a slim majority in the Senate. While President-elect Biden's party would loosely control both chambers of Congress, we believe he would still face constraints in enacting significant portions of his largely progressive agenda.

The Democrat's lead in the House of Representatives is extremely thin, as evidenced by the narrow re-election of Speaker Pelosi at the first meeting of the 117^th US Congress on January 3. There are also dueling coalitions of moderate and progressive Democrats who could disagree on many issues.

And with only 50 votes in the Senate, the Democrats would have no margin for dissension. West Virginia's Joe Manchin, who is often called a "Conservative Democrat," has already said that he will not support some of the Democratic agenda's progressive elements. Montana's Jon Tester, who is more of a moderate, hails from a fairly red state and would likely face criticism in his next election for backing highly progressive measures. Other Senators from swing states such as Arizona, Michigan and Pennsylvania may also feel constrained in how they can vote given their narrow election margins.

Clearing the path for more fiscal stimulus and tax policy reform

Nevertheless, the Senate runoff results would clear the path for more stimulus in the near term and the potential for some additional spending, as well as changes to tax policy through the budget reconciliation process.

We expect the $2,000 additional stimulus checks to be passed. After all, they have fairly bipartisan support. And Biden has mentioned that the $900 billion aid program passed in late December is just a down payment, with more stimulus coming under his watch.

Biden has also pledged to roll back some of the Trump tax cuts, raising rates for high income earners, corporations and capital gains. We think this part of his plan may be stymied, especially while the economic recovery is still very tenuous. The more moderate members of his party would probably push back against such large increases as well.

To accomplish their spending and tax objectives, the Democrats will likely use the budget reconciliation process in the Senate, which both parties have done in recent years. This process has some odd quirks but essentially allows a budget-related bill to pass the Senate once a year with a filibuster-proof simple majority, instead of the normal 60 votes.

The flip side of this coin is that to pass a bill through budget reconciliation, it must not increase the deficit after 10 years. So to meet Biden's lofty spending goals, the Democrats would need some form of increased revenue generation. However, this constraint has been pretty weak in the past — easily got around with creative accounting — as evidenced by some of Trump's budgets that were clearly not deficit neutral.

Likely beneficiaries: Democrats have been pushing for more aid to state and local governments, along with more funding for education. Green energy and infrastructure projects are likely to be a large part of the Democratic spending package. So we could eventually see greater issuance of green bonds. Raising the corporate tax rate to 28% from 21% would make municipal bonds more attractive for banks, life and property & casualty insurers, who account for about a quarter of tax-exempt muni holders.

Smoothing the path for Cabinet and judicial appointments

So far, Biden has largely announced a more moderate Cabinet that he deemed able to get through a Senate confirmation process — even if the Democrats did not win the two seats in Georgia. However, that process has often been messy and drawn out when the President's party doesn't control the Senate. With the Democrats holding 50 seats, the Cabinet position confirmations could go much more smoothly. With his team in place quickly, Biden's regulatory policy could probably resemble something closer to what he had originally hoped.

The Trump administration purged a lot of regulation from the books, and the Biden administration has pledged to reinstate many of those provisions and to add new ones. Some of these policies could be a surprise to risk markets, so this may be the most underrated conclusion from the election — with the potential for an outsized impact on specific companies, sectors and even asset classes at various points over the coming months.

Bottom line: In terms of financial market impacts, we could see inflation expectations continue to rise on the back of more fiscal spending. The federal government would also keep running large budget deficits, requiring a lot of US Treasury (UST) issuance. Coupled with inflation, that would put some pressure on interest rates, all else equal.

However, that ignores any action taken by the Federal Reserve, which may step in with some sort of Yield Curve Control policy if the UST curve steepens too much or if rates start to back up so much that they negatively impact stocks and other asset markets. The Fed recently adopted a longer-run average inflation targeting framework, so we suspect that a little inflation in the near term is unlikely to frighten them into tightening monetary policy too soon.

New York & Boston - While few people are likely to look back fondly on 2020, at least bond investors had the solace of finishing out thmake e year with solid returns. Which isn't to say they didn't face challenges: With 2020 volatility well above average, it was a year in which the market rewarded patience and strong stomachs.

If 2020 has taught us anything, it's that the unanticipated can and will happen. That said, here are the themes we believe will be relevant in 2021. Our consensus is for a modestly upward bias to rates and a steepening of the yield curve. Overall we believe credit will improve, but improvements will be uneven and some issuers will struggle. If we're right, we expect a laddered portfolio supported by credit research to perform well.

What does 2021 hold for the corporate bond market?

Investors will long remember 2020 as the year that condensed an entire credit cycle into a nine-month period. Reflecting positive investor sentiment coming into the year, the spread on the ICE BofA/Merrill Lynch 1-10 Year US Corporate Index improved slightly during January, coming within four basis points (bps) of its postcrisis low of 72 bps. However, the rapid spread of COVID-19 and a breakdown in Saudi-Russian oil negotiations created a historic economic disruption.

Credit spreads, particularly in the energy sector and others directly impacted by the economic shutdown, moved sharply wider as a result, briefly exceeding 400 bps. By the third week of March, the index's year-to-date (YTD) return had reached -7.75%. The drawdown in the same index was a stunning -10.7% over one three-week period. Astoundingly, returns had completely reversed by the last days of 2020, ending the year just above their long-term average of 7.3%. Spreads finished the year within a few bps of where they started.

Decisive action by the Federal Reserve, coupled with substantial fiscal assistance to individuals and businesses, helped reverse both the economic and market decline. The turning point for corporate credit coincided with the announcement that the Fed would purchase investment-grade corporate bonds and some fallen angels as part of its quantitative easing program.¹ Demand, as measured by fund flows, has been positive almost every week since then, contributing to higher bond prices.

With Treasury rates falling to record lows and spreads narrowing sharply, companies took advantage of historically low financing costs by issuing a record $1.8 trillion in new supply, almost 60% more than in the prior year. Corporations used their new-issue proceeds largely to build cash on their balance sheets, which further bolstered investor confidence. As the earnings outlook continues to improve, we expect to see more management teams focusing on improving their balance sheets by tendering for high-cost debt with this cash. We expect that heavy 2020 issuance should materially reduce funding requirements and the new-issue calendar in 2021.

We believe the credit cycle has already successfully transitioned from distress to recovery. Business activity is clearly improving at a faster pace than expected and could gain momentum with the distribution of vaccines. The economy is better able to cope with periodic shutdowns than it was earlier in the pandemic, and the restocking of depleted inventories will further drive profitability in the coming year. However, unlike in past recoveries, the adage "a rising tide lifts all boats" is unlikely to apply: Consumer behavior will continue to evolve following the pandemic, highlighting the need for professional credit oversight, especially in the retail and leisure sectors.

We believe central banks and national governments will continue to provide a significant level of market support. The Fed has pledged to keep short-term rates low through 2023, and it continues to purchase large amounts of fixed income instruments through its quantitative easing program. These efforts should help keep intermediate Treasury rates from rising too quickly.

The Fed's corporate bond buying program was incredibly successful at restoring investor confidence and stabilizing credit markets. Should the need arise, we expect the Fed would propose reestablishing the program known as the Secondary Market Corporate Credit Facility, especially considering the modest amount of capital it required, using just $14 billion of the $250 billion committed.

Interest rates will likely start to move higher as the recovery progresses, but we expect rates to take years to fully return to prepandemic levels. With short-term rates locked near zero, we wouldn't be surprised to see the yield curve steepen as interest rates normalize. 

In light of our constructive economic outlook, we expect BBB-rated bonds to produce attractive returns. We also see value in BB-rated bonds, which may offer more potential for spread tightening than investment-grade bonds. Demand for BB-rated bonds has been strong, especially after the Fed included fallen angels in its buying program. If the market has indeed entered an upgrade cycle, many BB-rated bonds could become rising stars, moving back into investment-grade indexes and providing another boost to returns.

What does 2021 hold for the municipal bond market?

Municipals wrapped up a historic 2020, with broad-market muni indexes up more than 4% for the year. The market has largely recovered from the pandemic-induced liquidity crisis that sent prices plummeting in the first quarter and rattled investor confidence in a portion of their portfolio commonly viewed as a safe haven. Thanks to unprecedented fiscal and monetary measures, municipals have steadily regained the support of their primary investor base: individuals in high tax brackets. Investors poured an impressive $60 billion into muni mutual funds since May, making 2020 the fourth strongest year for fund inflows on record.

Solid demand also allowed muni issuers to bring a record $495 billion of new-issue supply over the year. Demand has in fact been so strong of late that the muni market begins the year looking very similar to the start of 2020, with AAA benchmark yields back near all-time lows and muni/Treasury ratios well within overvalued territory. We anticipate an improving credit landscape combined with potential rate-driven volatility as 2021 gets underway. In our view, municipals should remain a valuable building block of a portfolio designed to maximize after-tax income and return, but careful credit selection and positioning will remain critical.

A vaccine-led economic recovery is expected to fuel higher GDP growth in 2021. While the Fed intends to keep short-term rates near zero through 2023, and continue its monthly buying program of $120 billion in Treasuries and mortgage-backed securities, a strong economic recovery may cause Treasury rates to increase modestly above crisis levels. Continued strong fund flows and reinvestment amid light supply should support muni performance in Q1. However, with benchmark muni yields and AAA muni/Treasury ratios near all-time lows, an increase in Treasury yields may result in negative muni performance and trigger a brief outflow cycle. Given an improving credit landscape, we foresee strong performance following any rate-related sell-off.

Lawmakers ended months of negotiations with a massive year-end spending bill that included the second-biggest economic rescue package in US history. While the $900 billion package didn't include direct aid to state and local governments, it still offered plenty of support for municipal credit — $83 billion for education, $45 billion for transportation aid, $14 billion for mass transit, $10 billion for state highways and $2 billion for airports.

The measure should also help avert a double-dip recession next year. This is a credit positive, with the possibility of surging COVID-19 cases and added shutdowns weighing on economic recovery in the near term. While Democrats may face challenges seeking additional assistance for state and local governments in Q1, we nonetheless expect muni credit to remain resilient, since it survived 2020 with better-than-expected revenue numbers and only a minor uptick in defaults and bankruptcies.

According to Moody's, following a 5.5% decline in revenue in FY 2020, state revenues will decline in FY 2021 by an average of only 5% — but the median could be as low as 2%. These numbers are far better than the dire predictions made during the height of the crisis, when Moody's projected an 18% to 23% decline through 2021. As the economy improves following widespread vaccine distribution, we expect lower-rated segments of the market (A and BBB) to outperform. We likewise expect sectors most negatively affected by COVID-19 — including airports, transportation and larger cities — to outperform in 2021.

As the legislative agenda of the new administration comes into focus, we see the potential for the passage of a bipartisan infrastructure package. According to the Volcker Alliance, state and local governments provide about 80% of US public infrastructure spending. Therefore, such policy may result in another year of record issuance and offer muni investors the ability to participate in a US infrastructure renaissance.

Along those lines, we anticipate a growing trend of ESG-minded investors increasingly looking toward their muni portfolios to make a positive environmental and social impact. While most muni issuers serve a public good, a defined ESG mandate may target exposure to issues focusing on clean water, pollution control, renewable energy and education. An infrastructure package may also bring about a return of Build America Bonds, adding to what's already expected to be record taxable muni issuance in 2021. This would only expand opportunities in that growing sector of the muni market.

So-called safe havens, including certificates of deposit and money-market funds, have become marginally less attractive and are likely to remain so. While we could see Treasury yields lift off crisis levels, surging cases and delayed vaccine distribution could keep the market in its current state for a while.

For investors subject to high federal and state tax rates, particularly following the state and local tax deduction cap, munis can offer more yield compared with their taxable counterparts. As a result, they remain a valuable building block of a portfolio designed to help maximize after-tax income and return. If investors are in a high tax bracket and committed to having some duration in a portfolio, munis can be an attractive source. This is especially the case in lower-rated sectors of the muni market, particularly those sectors more affected by the pandemic. While we've witnessed spreads tighten since the March sell-off, we expect further spread compression to drive outperformance of the lower-rated tier of the muni market.

Bottom line: In 2021, as the availability of vaccines allows the economy to rebound, we expect modestly higher Treasury yields and a steeper yield curve. We believe the recovery will be good for corporate credit and that lower-rated muni issuers may outperform. However, the transformative effect of the pandemic on the economy will mean that the impact of the recovery will be uneven, which highlights the need for credit research. We see opportunities for active managers to exploit the inefficiencies of the muni market. For both corporates and municipals, a laddered strategy could perform well in our predicted environment. It remains our fervent hope that the travails of 2020 will be left behind in 2021.

^{1. Bonds downgraded from investment grade to high yield are known as fallen angels. This distinction is important because many investment guidelines, including those of index funds, generally require that an investment manager sell a bond if the issuer fails to maintain a required minimum credit rating and therefore falls out of an investment-grade bond index.}

^{ICE BofA/Merrill Lynch 1-10 Year US Corporate Index is an unmanaged index of investment grade US corporate bonds with maturities between one and ten years.}

Boston - The US Treasury has communicated that the Municipal Liquidity Facility (MLF) will not be extended beyond December 31, 2020. Let's look at the impact of this announcement on the municipal bond market.

Volatile market calmed despite limited use

Created as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act passed in late March 2020, the MLF was intended to provide $500 billion in lending capacity to certain cities, states, counties and revenue bond issuers. We believe the presence of the MLF helped to calm the volatile muni market during the COVID-driven downturn in early 2020.

To date, we have observed little impact on the municipal market from the announced termination of the MLF at the end of this year. One reason is that the MLF has barely been used thus far, and we expect it was unlikely to be used significantly in 2021. In fact, since its inception, only two municipal issuers have tapped the MLF:

1. State of Illinois drew down $1.2 billion from the MLF in June 2020 (and is expected to draw down an additional $2 billion before the MLF expires at year-end)
2. Metropolitan Transportation Agency of New York (MTA) drew down $450 million in August 2020 (and is expected to draw down an additional $2.9 billion before the MLF expires at year-end)

The $1.65 billion that has been borrowed through the MLF equates to just over 3% of the MLF's $500 billion capacity.

Muni market functioning well

Another reason for the limited impact is that the municipal market is currently functioning very well, as technicals remain positive. Fund flows into the muni market have totaled $31 billion year to date in 2020, which has helped to offset the robust bond issuance of $414 billion through October — a 23% increase from 2019.

To cite one recent example of the market's health, consider the successful pricing of $3.7 billion in bonds by the State of New Jersey. Just one month ago, this state was exploring tapping the MLF for deficit financing, but instead was able to issue bonds at a true interest cost below 1.95%, as the bond deal was significantly oversubscribed and traded up substantially in the secondary market.

Muni credit proving resilient but MLF still useful

Finally, municipal credit has proved to be resilient in 2020. In the spring of 2020, many forecasts estimated that state revenues could decline by 15% to 20% through fiscal year 2022. However, on a year-to-date basis through September, state revenues have declined just 1% compared to 2019. State revenues are highly correlated with GDP, and therefore could fall as the economy continues to grapple with COVID-related stresses.

The strength in tax receipts year to date in 2020 has been positive for state credit and the municipal market overall. Nevertheless, we believe that sunsetting the MLF may be negative for muni bonds, as it had provided a backstop for stressed issuer, and helped heal the market from bouts of illiquidity this past spring.

Bottom line: While the MLF may not be needed in today's strong market, its absence could accelerate a future sell-off stemming from a mutual fund outflow cycle or a headline-grabbing municipal default. The Biden administration could just re-instate the programs, but funding would need to be approved by a divided Congress, which has proven to be no easy task.