You may have seen a couple of notes from us over the past few weeks discussing markets and COVID-19. To break up the tone and for additional perspective, we thought it worthwhile to relay what we are hearing from our investment managers. Below are just a couple observations from the many conversations we are having with municipal bond managers about recent volatility in the investment grade muni space. The response was fairly consistent across the board and broke down into liquidity, valuation, and credit quality.
One manager mentioned that prior to a few weeks ago, municipal bond mutual funds experienced 60 straight weeks of inflows. That trend recently turned, however, and when the outflows came, they came at an unprecedented pace on the order of several billion dollars. There simply weren’t enough buyers to offset the rush out the door. Another manager highlighted that this was one of the downsides of the Volker rule that was released as a result of the Great Recession. Banks were prohibited from certain investing activities with their own accounts, whereas previously they often stepped in to provide liquidity to the market in times of stress. Another headwind was that with markets selling off, there was no new issuance. Newly issued debt serves as a valuable tool for price discovery, and with it gone, declines persisted. All managers believe that liquidity should improve in the coming months, but the behavior of mutual fund investors will remain an unknown factor on the market moving forward. Often when fund investors see negative returns from their municipal bond portfolios, they react negatively, creating additional outflows. Managers said that this is not uncommon and shouldn’t be viewed as an alarm. Several recent examples of such behavior included the 2016 election, 2013 taper tantrum, 2010-2011 muni scare, and of course the Great Recession in 2008.
A common metric used to compare the yields on muni bonds vs. the yields on U.S. Treasury bonds is the ratio between the two. This graph above shows the yield on a AAA rate 10-year muni bond vs. that of a U.S. Treasury. Given the tax benefits associated with municipal bonds and their generally high credit quality, muni bonds often yield less than corresponding Treasuries (i.e. the ratio is less than 100%). At more than 200% of Treasury yields currently, you can see that we have broken out to levels only seen once before, during the Global Financial Crisis. This will likely revert by a combination of falling muni yields (good for bond holders) or rising yields in Treasuries. Might this be a sign of increased concern regarding the credit quality of munis? Our managers are saying no for the investment grade munis they often own. One muni manager provided perspective that is fairly consistent with what we heard from the others. This is not a credit situation in their view – it is a dislocation caused originally by 1) rebalancing (selling munis to buy equities to get back to target) and then 2) simple fear that led investors to go all cash, selling everything with favorable liquidity.
Most of our investment grade managers spent much of 2019 raising the credit quality of their portfolio in a period when they did not feel like they were being compensated for taking on risk. According to managers, state and local governments are in much better shape today than they were pre-2008, with tax revenues up in 35 of the last 40 quarters, and fiscal year state tax revenue last year well ahead of expectations. They also built up rainy-day funds significantly over the past 9 years. COVID-19 is now highlighting short-term stress across several areas of the muni market. Managers are very much aware of the rapid changes and are stress testing their bonds for quite extreme shocks. As an example, for dedicated tax bonds, one manager is testing the bond with an assumption that we will see a 90% decline in taxable receipts for the coming quarter. We heard similar examples across toll-roads and other areas of the muni market. The broad response is that high quality investment grade municipal bond issuers are in a strong position to handle these outsized scenarios. One interesting example came from a bond manager highlighting a part of the market that has sold off tremendously as of late – airports. There has clearly been a decline in air traffic, but some airports have enough cushion to cover operating costs for more than 500 days without any revenue over the period. In short, even when looking at parts of the municipal markets that are facing the most stress, there are issuers on solid footing.
There are short-term liquidity concerns in the municipal bond market that are creating pricing dislocations similar to what we saw during the financial crisis. Managers are constantly updating their assumptions and stress testing their bonds for the current and coming economic contraction associated with the spread and response to COVID-19. With that in mind, they believe that much of the investment grade municipal bond market is well positioned to weather the storm, and see the current stress in the muni market more driven by technical factors like liquidity and rapid selling than by fundamental distress. We encourage everyone to remember that from 1970 through 2018, average defaults for:
- AA rated munis was 0.02%,
- A was 0.11% and
- BBB was 1.13%.
Average recovery in the event of default is above 60%, so even IF a portfolio was all BBB (which is not common) and you shock defaults to a hypothetical 2% vs 1.13% average and reduce recovery to 50% from 61%, we are looking at a total loss of approximately 1%.