Letter to Shareholders: December 31, 2020

 

Dear Shareholder:

There’s no shortage of articles discussing what an awful year 2020 has been. It’s been a tough year, especially given the unthinkable loss of life that COVID-19 has wrought. Instead of rehashing all of the trials and tribulations of 2020, I thought I would briefly discuss some of the more positive developments that occurred throughout the year and mention a few things to which we can hopefully look forward in the New Year.

The best news of all is that thanks to a very successful and unprecedented public-private partnership a number of vaccines for COVID-19 were developed in record setting speed. Since the novel coronavirus was first reported in late 2019, scientists, physicians, and drug companies around the world have conducted hundreds of research studies focused on the diagnosis, prevention, and treatment of COVID-19. Previously, the fastest vaccine development process was for the mumps vaccine, and that process took four years. It’s really quite remarkable to think that just one year after the onset of COVID-19, we have already begun rolling out vaccines to our front-line healthcare workers, overseas troops, and more compromised populations. With more hard work and a little luck, it’s possible that a good percentage of the population will have received a COVID-19 vaccination by the middle of 2021. Innovative mRNA vaccines developed by several of the leading drug companies are not only highly effective against COVID-19, but also offer the promise of a breakthrough tool that may be used in the fight against other viral diseases.

Another positive and somewhat counterintuitive thing happened this year: financial markets actually performed exceptionally well. In the midst of a global pandemic and the ensuing deep recession, financial markets exhibited a remarkable degree of resiliency. After a gut-wrenching sell-off in March fueled by the onset of coronavirus and liquidity concerns, both equity and fixed-income markets staged impressive rallies and finished the year up sharply. Among other things, an unprecedented level of intervention by the Fed helped support (and potentially inflate) asset prices.

The municipal bond market turned in a very respectable performance with the Bloomberg Barclays Municipal Bond Index providing a total return of 5.2% for the 12-month period ended December 31, 2020. Municipal bonds weren’t spared from the carnage in March (when interest rates soared more than 225 bps in just nine trading days), but the asset class bounced back with tremendous speed and force. Investment grade municipal bonds performed well as the year progressed, even as the number of COVID-19 cases continued to climb and more jurisdictions were forced to implement lockdowns that negatively impacted their economies.

While the pandemic has led to a significant decline in state tax revenues, the news on this front is not all bad. Just like COVID-19 has affected some sectors more than others, it has also affected some states more than others. States that are particularly dependent upon tourism and leisure industries and that have higher unemployment rates and higher virus transmission rates are generally seeing larger impacts on their economies and tax revenues. New York and California have been hit particularly hard. Nonetheless, many people are surprised to learn that state and local governments’ revenues, as a whole, have held up better than expected during these difficult times.

Several factors seem to explain the better than expected numbers. Unlike years with typical investment-driven downturns, 2020 was characterized by a dramatic contraction and re-expansion in consumption. Consumer spending accounts for rough 70% of GDP, so a quicker than expected normalization in consumer spending levels has helped considerably. State income tax receipts have remained relatively buoyant because the majority of the job losses have been concentrated among lower earners who pay a relatively small amount of income tax. Tax receipts have been especially resilient in states that rely on progressive income taxes, as higher earners have successfully adjusted to the work-from-home environment. Additionally, due to a recent change in the law, many states are now collecting taxes on online sales that have boomed during the pandemic. Higher stock market valuations have also led to an increase in capital gains tax collections in many jurisdictions (this should help underfunded state pension plans too). Low absolute yields have aided the COVID-19 recovery by allowing state and local issuers to refinance many projects that were originally financed at much higher interest rates. Lower mortgage rates have led to a housing boom that has resulted in higher property tax collections, which are typically used to support local municipal credits.

Aid to state and local governments via the CARES Act largely offset revenue declines for the last fiscal year that ended in June. However, the fight over additional direct federal assistance to states and cities continues in Washington. We would not be surprised to see a smaller, more targeted relief bill passed next year, but this is purely speculation on our part.

I’m not suggesting that states and cities are completely out of the woods at this point. To the contrary, most states and cities will be faced with making very difficult budget decisions in 2021. However, we continue to believe that the situation is manageable (with or without additional federal assistance). Unlike corporations, states and cities have a tremendous degree of flexibility and a variety of tools at their disposal to manage their finances.

Default rates for investment grade municipal bonds have stayed at low levels. The slight uptick in default rates this year has been confined to the high yield sector with nursing homes representing roughly 40% of the defaults, followed closely by land secured deals involving real estate and industrial projects. The number of credit downgrades of investment grade municipal bonds has also stayed exceptionally low. While the number of defaults will probably trend up next year, we think most of those defaults will continue to take place in the high yield sector. We don’t hold any high yield municipal securities in any of our single-state funds.

We are staying busy keeping a close eye on all of the holdings in our investment portfolios. Many of the factors that helped support the municipal bond market this year (e.g., favorable supply and demand patterns and a slow growth/low inflation environment) will remain intact next year. We expect municipal bonds will generate positive total returns again in the coming year. However, with low absolute rates and bond prices having already rallied strongly this year, it seems likely that much of the anticipated positive performance next year will be derived from coupon income and not price appreciation. Hopefully, we will see less market volatility in 2021.

Thank you for investing with us. Happy New Year!

Sincerely,

 

 

Allen E. Grimes, Ill President