Municipal Fixed Income

Bluebirds fly

This month, we’ll focus on the strong recovery in the muni market over the second quarter, which proved to be illuminating to municipal investors on a couple fronts.
August 2020

Our last Municipal Insights covered the first quarter of the year, focusing on the liquidity implosion in the municipal bond market. This month, we’ll focus on the strong recovery in the muni market over the second quarter, which proved to be illuminating to municipal investors on a couple fronts.

First, the municipal market is much more resilient than many believed — unfortunately, there is a large price to pay for this hardiness, as we will discuss later. The sharp recovery in muni bond prices in the second quarter led to solid returns. The Bloomberg Municipal Bond Index returned 2.72% for Q2, completely recovering from the sell-off with a year-to-date return of 2.08%, as of June 30, 2020. Year-to-date through July 29, 2020, the Index is up another 1.43%.

Second, we have not seen a significant uptick in municipal defaults, particularly for investment grade bonds that comprise the bulk of the $3.9 trillion municipal market. We are still in the early stages of recovery and the duration of the pandemic continues to be uncertain, but the reserves that many municipal issuers built up over the past decade has buffered the pandemic’s initial impact on various revenues, particularly income and sales taxes. Credit quality downgrades have also been muted; however, the outlooks for all municipal sectors have been lowered to negative. On a go-forward basis, we can expect downgrades to exceed upgrades over the next several quarters.

What helped the market recover?

When investors see munis trading at yields that are 200 to 800% of Treasury yields, it does not take long for cash to chase historically low muni prices. For example, in late March, the 10-year Treasury yield was 0.50% while 10-year AAA-rated munis yielded 2.65% — over 500% of the Treasury yield, a screaming buy for many. The month of April saw a few hiccups in price recovery, but by May, the food fight for munis was well under way and investors poured over $28 billion back into the asset class.

Monthly municipal fund flows ($ millions)

Figure 1 - Monthly municipal fund flows in millions of dollars

Source: ICI.

Additionally, the market volatility led to a shortage of new issues as issuers waited out the storm. This was the other side of the technical setup that drove muni prices higher — high demand with low supply. Municipal bond volume dropped 32% in April versus last year. Year-to-date, total new issue volume recovered, but tax-exempt volume declined 3% while taxable municipal issuance rose more than 250%. That’s a problem; retail investors in the U.S. do not want taxable munis and they hold over 70% of outstanding debt! This imbalance between tax-exempt supply and demand has continued through mid-July and we don’t see it changing through year-end as state and local governments continue to issue taxable munis.

Why are municipalities issuing taxable debt? Essentially, the answer lies in the elimination of tax-exempt advance refundings in 2017’s Tax Cuts and Jobs Act. Prior to the Act, advance refunding deals were 30% to 40% of total annual issuance. In the current crisis, the Fed has driven corporate bond yields to levels that make taxable muni issuance more compelling. The yield compression between corporate bonds and tax-exempt munis is tight enough for municipalities to recognize savings by issuing taxable munis to pre-refund their outstanding tax-exempt debt. Additionally, overseas investors, some of whom are facing negative yields, have increased purchases of taxable munis due to the relatively high absolute yields, in addition to using them as a means of diversifying risk.

How are municipal issuers faring so far?

The reemergence of investor demand, combined with Fed actions, has supported municipal operations by providing very low rates of long-term borrowing as well as an ability to secure short-term funding for liquidity needs. Many banks are providing direct lending to municipal entities thus bypassing the more costly new issue market. Additionally, many municipal issuers are taking advantage of very low taxable corporate rates to refinance their more costly, outstanding tax-exempt debt.

While far from being out of the woods, we don’t anticipate widespread defaults for the industry, particularly for the most common sectors of the muni market. Most of the increase in defaults and impairments will be in the high-yield sector. That said, municipal issuers across the country are facing immediate financial pressures from the sudden loss of revenues due to the shelter-in-place orders. Recent studies from the Center on Budget & Policy Priorities and the National League of Cities estimated revenue shortfalls to state and local governments over the next three years at $555 billion and $360 billion, respectively. Economic recovery will not occur as quickly as once thought and many issuers will take years to recover as was the case in the last great depression.

What gives us comfort in holding municipal bonds over many years?

  • Having a highly diversified portfolio helps with risk mitigation. On average, we like to keep exposure to a single municipal issuer under one-half of a percent.
  • We have a seasoned analytical team who review lower-quality bonds before purchase and actively monitor them until maturity.
  • We take comfort in the monopolistic qualities of issuers who use municipal bonds to finance construction and build the infrastructure for daily life: roads and bridges, water lines and sewer systems, hospitals, schools, police stations, airports, etc.
  • Municipal bonds have a very low rate of default. Since 1986, less than 0.3% of municipal issuers have defaulted in their first ten years, compared with 13% of corporate issuers.
    • The rating agencies have noted that while they expect some defaults, particularly in high yield, they do not expect a significant spike in defaults. Moody’s noted in a recent report that they do not anticipate any of the municipal issuers they rate to default this year due to COVID-19.
  • Municipalities have financial flexibility and can raise taxes, cut expenditures and staff, reduce services, establish lines of credit with local banks, use rainy-day reserves, and defer capital expenditures.
  • Typically, debt payments are a small portion of local government budgets. Governments primarily use serial maturity bonds over a 30-year period rather than term bonds, which are often used in the corporate market and can lead to “debt cliffs1.”
  • Municipal bonds contain additional security features for bondholder, such as legal oversight of debt service payments, monthly payments set-aside to trustee for debt service, and debt service reserve funds.

State and local employment levels (thousands)

Figure 2 - State and local employment levels in thousands

Source: Bloomberg Intelligence.

Where do you see opportunities in the muni market?

Airports

We expect recovery for airports to take longer than other municipal sectors, as leisure and business travel remain low due to recent upticks in COVID-19 cases, but this can create opportunities. Historically, air traffic has been very resilient following downturns. However, the model for business travel may see permanent changes.

The airport sector had a strong liquidity position at the beginning of the year as our holdings in the sector had a median of 414 day’s cash on hand. We favor large urban center airports with ample cash positions, diversified carriers, and a mix of passenger and cargo traffic.

Recent federal aid to airports is approximately 20% to 30% of 2018 revenues and can be used for any purpose. We see continued federal support for the facilities given that the aviation industry represents a significant contributor to the economy, representing over 11 million jobs and 5% of U.S. GDP, according to the FAA.

Airport bonds generally include debt service reserve funds, and they maintain liquidity through commercial paper, bank lines and cash reserves. We are avoiding airports with large capital programs, cruise exposure and significant international traffic. To date, Moody’s has only downgraded two airport facilities, both privately managed international terminals at the John F. Kennedy International Airport.

Toll roads

Despite the pandemic’s severe impact on traffic due to work-from-home, school closures and online shopping, most toll road authorities are in a strong financial position to weather COVID-19. Moody’s noted that the managed toll roads it rates have at least 365 days’ cash on hand, and that most have an additional 12-months of debt service reserves. This strong liquidity position could help support toll roads through the next year.

With about $140 billion in outstanding debt, investors have ample opportunities to invest in this market. We favor toll roads in urban centers with a mix of commuter and commercial activity. We look for strong bondholder protections including debt service reserve funds, rate covenants and rate-setting capabilities. We also look for systems with electronic tolling and strong collection procedures. Likely, many of you have received a surprise collection notice in the mail from a missed toll while on vacation.

There are several relatively new toll roads in Texas that have additional reserves to support their debt, including rate stabilization and maintenance reserve funds.

Local general obligation (GO)

This sector includes GO debt issued for local school districts as well as those for general purpose. It tends to benefit from the relatively stable stream of property taxes that are typically used to pay principal and interest in this sector. And unlike the last recession following the housing collapse, although number of sales may be down, the real estate market has not been negatively impacted at this point in the downturn. Additionally, if we do see a decline in housing prices, there is usually a two-year lag before property taxes fall because of the timing of property value reassessments.

School district GO bonds also benefit from strong support from their respective states and, even in this environment, we do not expect that support to end. Many school bonds also benefit from enhanced credit ratings due to a variety of state programs, including State Permanent Fund, State Guaranty, Annual State Appropriation and State Aid Intercept.

Summary

For the next two quarters, the technical picture for the muni market looks promising. We believe demand for munis will increase as we head into a volatile presidential election. If we see the White House switch parties, 2021 would likely see higher individual and corporate income tax rates. This would drive demand for tax-exempt munis higher. This outlook is likely responsible for some of the recent price gains munis have posted. Meanwhile, on the supply side, municipal taxable issuance will continue to reduce the availability of tax-exempt bonds. There have also been discussions on Capitol Hill (“I’m just a bill, yes I’m only a bill”) of reintroducing a program similar to The Build America Bond (BAB) program in late 2010. This would also sharply reduce the issuance of tax-exempt bonds.

On the credit side of the equation, we have not seen an uptick in municipal defaults in the investment grade sector. There has been an uptick of payment defaults and impairments in the muni high-yield sector, but many of those have been for more relatively obscure financings for malls, skating rinks, jails and solid waste projects. However, we have seen an uptick in both defaults and impairments among continuing care facilities that requires close attention. We have also seen an increase in credit and credit watch downgrades. But we expected this to occur. While there are still many unknowns, we will have to wait to see how the pandemic ultimately impacts credit quality. Hopefully, the rainbow is right around the corner.

Current Positioning and Outlook

Duration

  • The March liquidity crunch caused extreme volatility in many markets. However, we maintained longer duration through the sell-off and quick rebound. The Fed will likely anchor the short end of the yield curve at the zero lower bound through 2022.
    • Uncertainty in the economy and duration of the pandemic will necessitate close attention to the Fed’s forward guidance.
  • Investor flows have been focused on long muni bond funds to pick up additional yield. With continued Fed support , this is likely to continue through year-end. Given that, we will continue to maintain an extended duration for the foreseeable future.
  • With the financial system flush with cash from the Fed’s ballooning balance sheet, we will be mindful of the possibility for accelerating inflation but not until late 2021 or 2022.

Yield curve and structure

  • Yield curve control (YCC) — or yield caps — has been discussed by the Fed, and is a possibility later this year. Speculation around what spot to target for YCC is focused on 3- to 5-year Treasury bonds, but it’s possible the Fed could target 5- to 10-year bonds to have a bigger impact.
  • Thirty-year municipal bond yields fell 40 bps over the second quarter, while yields on the short end of the curve fell as much as 80 bps.
  • Municipal yields remain elevated relative to Treasury yields (over 100%) and are likely to remain there due to overhanging credit concerns, as long as revenues remain under pressure from relapses in state lockdowns across portions of the country.
  • There has been an increase in new issues with 3% to 4% coupons on longer maturities. With short rates anchored and the possibility of YCC, these should be considered as historically they have offered 20 to 30 bps of additional yield over the traditional 5% coupon structure.
  • The weekly municipal floating rate index (SIFMA) is 0.21% (07/15/20) versus 1.27% a year ago.
    • We think SIFMA will remain at a very low level for the foreseeable future. For reference, SIFMA was below 0.40% from June 2009 through March 2015. The dividend yield on tax-free money market funds will likely remain tight to SIFMA.
    • Ultra-short muni funds may be a good alternative to pursue additional yield.

Credit

  • While credit quality spreads have tightened significantly since March, they remain elevated versus historical averages, particularly for BBB-rated bonds and high yield munis.
  • Sector and credit selection will be the primary drivers of performance over the next few quarters, and will require fundamental and technical expertise to navigate.
  • All sectors should have offerings that provide value. We will be analyzing the risk/reward of many different investments, notwithstanding the potential for heightened market volatility.

Sector and geography

  • The sectors hardest hit by the lockdown have been those most reliant on the consumer, hospitals, toll roads and airports. These sectors continue to provide some of the best opportunities for relative price improvement over the next few quarters.
  • The odds of an infrastructure bill remain low until after the November election.
  • The impact of global warming on municipal issuers across the country is slowly becoming more apparent. However, the tools to implement risk controls on this front remain limited, but we will continue to look for ways to improve this analysis moving forward.
  • Let us not forget the growing importance of environmental, social and governance (ESG) qualities of municipal issuers. Competent and experienced governance will benefit issuers in the coming years as the economy navigates this dramatic shock to output.

Positioning and outlook is subject to change without notice. Market conditions and trends will fluctuate.

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Disclosures

All investments involve risk, including the possible loss of principal.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. All of these factors can subject the funds to increased loss of principal.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall.

Municipal bonds are subject to risks including economic and regulatory developments in the federal and state tax structure, deregulation, court rulings, and other factors.

Diversification neither assures a profit nor guarantees against loss in a declining market.

The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year. Investments cannot be made in an index. The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Bps (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

Views and opinions have been arrived at by BMO Global Asset Management. The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

Interest income from tax-exempt investments may be subject to the federal alternative minimum tax (AMT) for individuals and corporations, and state and local taxes.

Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.

You should consider the Fund’s investment objectives, risks, charges and expenses carefully before investing. For a prospectus, which contains this and other information about the BMO Funds, call 1-800-236-3863. Please read it carefully before investing.

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