2021 Investment Themes: Opportunities in the Dawn of a New Cycle
PGIM asset managers share key investment themes likely to drive markets in 2021 and strategies for investors to capitalize on the opportunities they may bring.
A: The municipal bond market is inefficient and unique in many respects. Active management can help convert inefficiencies into opportunities. The fragmented $3.9 trillion market is spread across more than 50,000 issuers.1 For perspective, the U.S. corporate bond market is closer to $10 trillion across 6,000 issuers—in short, the municipal market has more issues of smaller size.2
A: We believe municipal bonds are attractive in the current environment. They have historically performed well in a falling-to-low interest rate environment, offer attractive taxable-equivalent yields, and exhibit lower default rates than U.S. corporate credits.3 Moreover, due to pandemic-related spending and the expansion of the federal debt, top marginal personal income tax rates at the federal level are unlikely to get cut any time soon.
In the short term, a supportive technical backdrop featuring limited net issuance and continued inflows should remain intact through early 2021. The confluence of election uncertainty, historically low interest rates, the COVID pandemic, and a policy change pulled a significant amount of municipal tax-exempt and taxable issuance forward in 2020. The supply that was pulled forward sets the market up with a highly supportive backdrop heading into 2021 as net tax-exempt supply is expected to remain negative through the end of the year. Despite attractive valuations and a stable, low-interest-rate backdrop, investors should take note of a few risks, including lack of additional federal aid for states and localities. On the fundamental side, municipal issuers are experiencing widely different levels of stress in response to the COVID crisis. In this environment, an active manager with careful analysis and security selection can add significant value over passive strategies.
Market dislocations often lead to great investment opportunities.
A: COVID has had temporary and potentially longer-term effects on certain tax-exempt municipal issuers. Foremost, many higher-quality credits have demonstrated their resiliency following the disruption whether they are states, essential service utilities, hospitals, universities, or other issuers. We expect this trend to continue. Longer term, states and other municipal issuers that were already struggling pre-pandemic will have a harder time making up any financial shortfalls.
Across sectors, essential services such as water, sewer, and public power experienced fewer dislocations. Toll roads, airports, and transit all took an initial hit given the lockdowns and subsequent decline in revenues. Most established toll roads with heavy commercial traffic held up well and volume has improved as the lockdowns eased and individual drivers took to the roads once again.
Most major airports were well positioned from a liquidity and cash reserve perspective going into the crisis and subsequently received funding as part of the CARES Act. We expect leisure air travel to make a recovery post pandemic, while business travel may take longer to ramp up.
Transit is a tougher call. Ridership volumes have improved but remain low in major urban areas as more individuals are still working from home or opt to drive. While most transit systems received funding under the original CARES Act, they may still need support from local, state, and/or federal governments until ridership improves.
A: In response to COVID, the federal government passed the CARES Act, which included $150 billion in funds for municipalities to cover COVID-related expenses as well as funding for hospitals, airports, transit, and higher education. The Federal Reserve also introduced the Municipal Liquidity Facility (MLF) as a backstop for eligible issuers across the U.S municipal landscape. The MLF allows eligible issuers to borrow from the MLF for up to three years, which can help issuers address budget gaps. To date, the MLF has been accessed by two lower-rated credits: The State of Illinois and New York’s Metropolitan Transportation Authority. The Fed has been responsive to market conditions and has expanded and adjusted certain MLF terms accordingly. Although the program is set to expire at the end of 2020, additional support may be introduced in the future if deemed necessary by market conditions.
A: We expect select A and BBB credits to outperform higher-rated segments as spreads in these quality ranges remain wide relative to pre-COVID levels and may present select opportunities. For example, in the spring we added certain BBB-rated hospitals that are essential service providers at attractive spreads, which have since tightened. We also opportunistically added airport and toll road credits to portfolios.
Within the various revenue categories, we expect transportation, hospital, and tobacco credit spreads to continue tightening. Within the higher education sector, higher-rated universities have the resources to weather revenue declines, while smaller, private colleges in the BBB-rating category remain vulnerable.
Absent another round of fiscal stimulus, we would expect select states and municipalities to implement additional layoffs and expenditure cuts, and to seek new sources of revenue through increased taxes and other fees. We expect certain high yield municipal credits that are dependent on narrow revenue streams, such as certain senior living facilities and convention center bonds, to face continued pressure, which could result in higher default levels among these issuers.
As already noted, higher-quality credits across sectors are better positioned to weather the current dislocations caused by COVID and should remain the bedrock of a well-diversified municipal bond portfolio.
A: We manage the PGIM Muni High Income Fund as a higher-quality, high yield fund. We believe this type of vehicle has better liquidity, quality, and diversification than other high yield funds that may have a larger concentration of non-rated bonds and exposure to smaller, project finance type issues, including energy-related credits. In general, bid/ask spreads will be wider for non-rated credits and traded by a smaller group of dealers.
While the credit impact of COVID has resulted in some rating downgrades and credit outlooks being revised lower, overall, we do not expect a large pick up in municipal defaults or fallen angels, unlike the U.S. investment-grade corporate bond market. A key reason is that BBB-rated municipal bonds represent only 8% of the tax-exempt Bloomberg Barclays High Grade Municipal Index vs. 49% for the U.S. corporate bond market as measured by the Bloomberg Barclays U.S. Corporate Bond Index.4
Experience plays a large role. PGIM Fixed Income’s municipal portfolio managers average 22 years of investment experience and 19 years with the firm as of September 30, 2020.
Our security selection process is based on a research-intensive approach. The municipal bond portfolio managers are paired with senior municipal bond research analysts and benefit from a collaborative research process where analysts provide internal fundamental ratings, while portfolio managers assess market dynamics and security pricing for each municipal issuer to determine the relative value of each investment. Often, these internal ratings diverge significantly from the major credit rating agencies. In-depth analysis, as well as risk budgeting and scenario analysis, are ongoing exercises that add value for the portfolios. In addition, we leverage the firm’s 120-member fundamental research team for regional insights and industry and credit-related themes. Our 61-member internal Quantitative Research and Risk Management team provides risk budgeting, relative value tools, and risk reporting on a daily basis.
We believe this collaborative effort helps us develop diversified portfolios that are built through the integration of credit research, quantitative research, and risk budgeting that can achieve consistent returns in excess of the benchmark over time.
1Municipal Securities Rulemaking Board (MSRB).
2Federal Reserve, FINRA, Moody’s, MSRB, SIFMA, Standard & Poor’s, World Federation of Exchanges.
3MSRB as of December 31, 2019.
4 Bloomberg Barclays as of September 30, 2020.
Risk Information—Fixed income investments are subject to credit, market, and interest rate risk, and their value will decline as interest rates rise. Investing in municipal bonds involves credit and market risks. The fund may invest in high yield (“junk”) bonds, which are subject to greater credit and market risks; leveraging techniques, which may magnify losses; and derivative securities, which may carry market, credit, and liquidity risks. The fund is subject to fixed income obligations and municipal bonds risk, where the fund's holdings, share price, yield, and total return may fluctuate in response to bond market movements and municipal bond market movements. The risks associated with the fund are more fully explained in the prospectus. These risks may increase the fund's share price volatility. There is no guarantee the fund’s objective will be achieved. Diversification does not assure a profit or protect against loss in declining markets.
Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. This information must be preceded or accompanied by the current prospectus or summary prospectus for the fund. The prospectus and summary prospectus contain information on the investment objectives, risks, charges, and expenses of the fund and should be read carefully. Contact the PGIM Investments Sales Desk at (800) 257-3893 to obtain the prospectus and summary prospectus.
Mutual funds are distributed by Prudential Investment Management Services LLC (PIMS). PGIM Fixed Income is a unit of PGIM, Inc. (PGIM), a registered investment advisor. PIMS and PGIM are Prudential Financial companies. © 2021 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
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1043844-00001-00 Ed: 01/2021
Consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus and the summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and the summary prospectus. Read them carefully before investing.
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