What helped the market recover?
Monthly municipal fund flows ($ millions)
How are municipal issuers faring so far?
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)
Where do you see opportunities in the muni market?
Local general obligation (GO)
Current Positioning and Outlook
- 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.
- 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.
All investments involve risk, including the possible loss of principal.
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.