Municipal Fixed Income

The state of the municipal market

There will be an increase in defaults, but we believe they will largely occur in the muni high yield space of below investment-grade credits.
April 2020

What caused the extreme municipal market volatility in March 2020?

In a nutshell, fear and panic. But that’s understandable in the face of a virulent, deadly enemy that you can’t see and is difficult to contain without mass testing. The unknown is menacing, and investors reacted as they have historically — by raising cash and improving liquidity. In many ways, it is similar to the 2008-09 crisis when the bursting housing bubble caused an indiscriminate rush to sell any assets other than Treasuries. What was shocking this time was the unprecedented speed of the sell-off, and the ensuing recovery. Even after 30 years in the business, it was quite alarming. There are a number of reasons for the quick decline in bond prices:

  • Significant market increase as many investors piled into municipal bonds (munis) over the past year
  • Historically low interest rates due to increased demand
  • 70% concentration of munis’ retail ownership (direct and indirect with funds)
  • Limited committed capital of dealers/banks due to banking reforms after the 2008-09 recession

The municipal market, like many other markets, was primed for this type of dislocation. When there are a large percentage of muni holders acting with the same mindset, there will be too many sellers at once, causing liquidity to become a depressing force on bond prices. As investors exited muni ETFs and mutual funds, portfolio managers were forced to show large lists of bonds for sale to the broker-dealer community if they did not have enough cash for redemptions.

Typically this process is orderly, with the average daily number of individual bonds out for bid at about 3,000. Placing bids on that many bonds is quite an accomplishment for municipal bond traders in a normal market. However, investor selling intensified through March and totaled a whopping $44 billion of net outflows from muni funds and ETFs — a monthly record by far. As a result, the number of bonds out for bid spiked to 11,843 per day. This represents over $4 billion in total par (Figure 1). This makes for an incredibly sloppy market, but also a myriad of opportunities for those with cash to spend.

Daily total return: 10-year Bloomberg Municipal Bond Index - January 2 to April 6, 2020

State of the Municipal Market chart

Source: Bloomberg.

Heavy secondary market selling over a short period depressed prices, which led to more investor outflows and a further depressing of prices.  It can be a vicious cycle in times of panic and uncertainty.

Thankfully, these liquidity events do not occur often and are short-lived. After a week of heightened selling and negative returns, muni bonds became cheaper than many taxable bonds and attracted atypical buyers. These crossover buyers included banks, insurance companies, and hedge funds that saw the value in munis. This effectively provided a floor on prices, stabilized the market, and helped munis recover to positive daily returns of as much as 3% the following week, as represented by the Bloomberg Municipal Bond Index. This crossover behavior is not unusual for the muni market, having seen it several times in the past three decades. Nonetheless, this panic-induced selling is stressful for investors and for those of us managing the $3.9 trillion muni market. Needless to say, we like long-term, buy-and-hold investors.

Is liquidity improving in the municipal market?

While realizing there is no guarantee if the market will continue on this path, we’ve seen considerable improvement. As we start the second quarter, it’s clear that the world’s central banks and governing bodies are working relentlessly to enact a myriad of monetary and fiscal policies to soften the global impact of the pandemic shutdown. In March, the Federal Reserve (Fed) slashed rates by 150 basis points to the zero lower bound (one percent of yield equals 100 basis points). This jolt of monetary policy provided limited relief in a world of mandatory shelter-in-place orders, intense risk aversion, and the ensuing flight to cash.

More needed to be done to help grease the skids. The Fed went all in and announced that it would buy an open-ended amount of Treasury and mortgage-backed securities (MBS). This was aimed at reducing the volatility in these higher-quality markets. The yield on the 10-year treasury fell by 60 basis points over the following days. However, the Fed needed to directly support entities severely impacted by shelter-at-home orders — small businesses, various corporate sectors as well as broader credit markets.

A solution was crafted by lawmakers at the end of March: the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which provides $2.2 trillion (roughly 10% of U.S. GDP) of relief to various entities.

Specifically pertaining to the municipal market, the CARES Act allotted $454 billion to the Treasury to support Fed programs. The Treasury will use that cash to make loans to Fed facilities or programs which provide liquidity to the financial system. Ultimately, these programs will be able to support lending to municipalities, states, and businesses by purchasing bonds directly from these issuers, buying the issuers’ obligations in the secondary market, or by making other loans secured by collateral. The kicker is the ability of the Fed to leverage the $454 billion to perhaps as much as $4 trillion of additional liquidity. This is a new world. The Treasury is backstopping the loans as the Fed acts as the banker and facilitator.

The Fed has chosen BlackRock to administer the programs and purchase the various securities. While we are not aware of the implementation of these programs at this time, the new ability of the Treasury and Fed to act in this joint manner has lessened risk aversion and improved liquidity. Albeit, many people are upset with this new level of federal support for corporations.

What else is the Federal government doing to help municipal issuers?

They are off to a good start with a historically massive fiscal spending package. The CARES Act authorizes the Treasury to:

  • Pay $150B to state, local, tribal and territorial governments. Of this:
    • $3B to the District of Columbia and US Territories.
    • $8B to Tribal governments
    • $139B to states in proportion to the population. For example, we estimate $15B for California, $7.5B for New York, and $5B for Illinois
  • Provide $117B for hospitals and eliminate $4B in Medicaid cuts that were scheduled to hit hospital revenues this year
  • $10B for airports, $25B of loans directly to airlines, and $4B to cargo air carriers
  • $25B for transit systems
  • $31B for the Education Stabilization Fund

 

Earlier in March, Congress and the Fed provided a variety of support measures, including:

  • $950 million to state and local health departments
  • President Donald Trump declared a national emergency, allowing the Disaster Relief Fund to reimburse 75% of the costs associated with the virus
  • The Fed created a Money Market Mutual Fund Liquidity Facility to facilitate loans to banks to purchase assets from municipal money market funds

 

With many other fiscal stimulus packages not named, our primary message is that this is a staggering amount of relief money, with the possibility of more to come. And municipal issuers will need every bit they can squeeze out of Washington. Congress is already discussing the next stimulus bill, which is expected to total at least $1 trillion. House Speaker Pelosi wants the bill to provide more assistance to state and local governments, with an emphasis on communities with fewer than 500,000 residents. As the pandemic starts to ease, how sustainable the recent bipartisanship will be is uncertain. It may not last long enough to progress on badly needed infrastructure spending.

How has performance been?

At the end of the quarter of 2020, performance was not as bad as one might have thought given the investor outflows. At the peak of last month’s sell-off, the broad Bloomberg Municipal Bond Index fell by 10.42% month-to-date through March 23. That large of a downturn has not been recorded since August 1981. Thankfully, the extremes of the liquidity crunch were short-lived and the muni market recovered over the final two weeks of the quarter, leaving March’s return down 3.63%. For the entire first quarter, the Index posted an acceptable decline of 0.63% given the circumstances. In the intermediate portion of the curve, the Bloomberg 1-15 Year Muni Index returned a negative 2.92% for March, and a negative 0.50% for the first quarter.

With the economy screeching to a halt and a recession in our midst, credit quality will have a more significant role to play for the next few quarters. Spread widening has already hindered returns on lower-rated issuers. For example, Bloomberg’s BBB Index returned a negative 2.15% for March, versus a negative 0.52% for the AA Index. As you might expect, the Bloomberg Muni High Yield Index was the worst Bloomberg Muni Index performer, down 11% in March. While we believe there is room for more spread tightening after last month’s dislocation, ultimately, quality spreads will likely not return to the historically tight levels in place at the start of the year anytime soon. There is a slight chance investors head back into the high yield space if the economic downturn is short-lived, but we do not think this is likely.

More importantly, performance may largely be driven by investors. Do they stay or do they go?

What is the analyst community thinking?

With the large decline of various revenue streams for tax-exempt issuers, we expect a broad deterioration of issuer credit quality. We’ve already seen transportation sector outlooks turn negative, which we expected given the domestic lockdown. For example, in a March 16 press release, S&P revised its airport sector outlook from positive to negative. A negative outlook on a sector does not necessarily lead to mass rating downgrades. However, it indicates that the rating agency expects market trends to have a negative influence on issuers operating in that sector over the near to intermediate term.

Municipal credit analysis is not black and white. There are many grey areas open to varying analyses from different analysts — part art, part science.

The negative outlook for a particular sector does not imply that all issuers within that market sector will be negative. Over the next several weeks, S&P will survey its airport portfolio to gauge the impact of the current environment. In the same press release, S&P stated that the liquidity positions of transportation credits will suffer as issuers address near-term pressures. The ratings agency also noted that the average liquidity position of the transportation sector is generally solid at 600 days of unrestricted cash on hand.

An April 1 airport presentation by Moody’s Investors Service was titled, “Strong liquidity insulates U.S. airports”. The bullets from that presentation slide include:

  • Unrestricted cash sees almost all airports through prolonged ‘no revenues’
  • Federal stimulus keeps liquidity strong while demand decouples from the economy
  • Fragile economic conditions will be the largest threat to credit deterioration
  • 12-month debt service reserves add protection

The analysis included an estimated cash increase from the federal stimulus programs. S&P may come to a similar conclusion, so we will watch this closely over the next several weeks. We are relying on our analysts for sector opinions to help guide us through this crisis, as we did in 2008-09.

What’s our outlook ahead?

Rating agencies have already commented that they do not expect widespread defaults in muni-land. There will be an increase in defaults, but we believe they will largely occur in the muni high yield space of below investment-grade credits — namely, project financings and continuing care facilities.

We’re not trying to scare investors out of municipal high yield funds, but we don’t want to sugarcoat it either, since this current volatility is uncommon. Those funds typically have good credit diversification as well as a team of highly experienced analysts. These two factors can help provide opportunities for  performance over longer periods of time — a philosophy we share. There is expected to be an uptick in bond covenant violations (which is a technical default), but these covenants were put into place for bondholder protection. Most investors never hear about these technical defaults because they are corrected within the allotted timeframe.

The moral of the story? Don’t believe everything you read. Segments of the media are still prone to focus on negative events that they can sensationalize. Focusing on these stories can shake your confidence. Listen to your financial advisors, or consider putting your cash in a diversified fund managed by professionals and experienced analysts.

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Disclosures

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. This may have an adverse effect on a Fund’s portfolio.

Credit risk is the possibility that an issuer will default on a security by failing to pay interest or principal when due. Lower credit ratings correspond to higher credit risk.

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

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

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.

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. Basis points (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.

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