July 15, 2020
Since their severe liquidity disruption in March, high-grade muni valuations have clawed their way back toward pre-pandemic levels. However, they remain compelling relative to many taxable alternatives.

What Happened

At the onset of the pandemic, investors looked to their more stable assets to raise cash positions, leading to indiscriminate selling of high-quality fixed income assets in late March. Sellers overwhelmed the diminished pool of buyers, sending municipal bond yields sharply higher (i.e., significantly lower prices). As the Federal Reserve (Fed) rushed to restore order in the US fixed income markets, the municipal market found its footing and fashioned a record-setting rally. However, the muni recovery lagged the advance in US Treasuries, creating a historically large disconnect between the yields of AAA-rated municipals relative to US Treasuries of the same maturities. Muni-to-US Treasury ratios that historically averaged 80% soared above 400% in some parts of the yield curve (a higher ratio indicates that munis are more attractive on a relative basis).

The combination of the limited policy relief provided directly to muni issuers and the unique impact of COVID-19 on state and local governments has restrained muni performance. Three months later, the US municipal bond market still awaits much-needed relief from Congress and the Fed. As a result, a rare level of relative value remains in the muni space today. Using a 37% federal tax bracket, the taxable equivalent yield of a 10-year AAA-rated general obligation municipal bond is approximately 1.20%, roughly double the yield offered by a 10-year US Treasury bond. AAA Muni-to-US Treasury ratios still range from 100-140%, depending on the maturity.

Near-Term Outlook Positive For Munis

Fiscal Policy Support On the Way

There appears to be bipartisan support mounting for relief targeted directly at states and localities to carry them across the crisis. If an agreement can be reached, we would expect a meaningful boost in municipal market sentiment. In the near-term, we expect Congress to pass some iteration of the $3 trillion HEROES Act put forth by the House in May. In its current form, the bill would provide $500 billion in state-level funding and almost $400 billion to eligible cities and counties. The Federal Reserve Bank of Cleveland estimates that the economic shutdowns used to mitigate the virus’s spread will create shortfalls upwards of $200 billion by the end of 2021. The aid currently included in the HEROES Act far surpasses these projections and would go a long way to backfill lost sales and income tax revenues and pay for COVID-related expenditures, such as further mitigation measures, healthcare costs, and modified school reopenings.

Monetary Policy Flexibility Remains

In April, the Fed established the Municipal Liquidity Facility (MLF). Its creation alone helped correct the muni market’s liquidity concerns by providing a tangible backstop – a lender of last resort. However, the steep borrowing costs through the MLF have severely limited its use thus far. A more accommodative MLF would likely push AAA Muni-to-US Treasury ratios towards historical norms through a muni rally.

Given its “whatever it takes” stance, we believe the Fed would ultimately reconsider the MLF’s strict rules to ease its eligibility requirements and the interest rates it charges if: 1) muni liquidity deteriorates again and 2) tangible evidence emerges that a wide array of municipalities cannot bear the financial burdens placed upon them by the pandemic.

Supportive Seasonal Trends

Demand for tax-exempt municipal bonds remains very strong. The summer months tend to provide a busy period of reinvestment activity. Additionally, the uncertainty surrounding the US recovery is fostering demand for safe haven assets like high-grade munis. Since their initial disruption, investment grade munis have provided sturdy ballast for a volatile global equity backdrop. Lastly, the upcoming elections in the US have market participants weighing the potential for higher taxes which increase the value and demand for tax-exempt securities.

Bottom Line

The lack of federal relief for municipalities has created an atypical yield differential and a relative value opportunity in municipal bonds versus taxable fixed income alternatives. Our expectations of forthcoming federal support, likely monetary policy backstop, and demand driven by seasonal trends and investor uncertainty due to a long and uneven economic recovery process, suggest Muni-to-US Treasury ratios should fall toward more normal levels.
Our yield curve analysis suggests that the 1-5 year and 10-15 year ranges offer the greatest amount of relative value, though the 10-15 year comes with heightened interest rate sensitivity.

We continue to favor high-quality general obligation issuers with proven track records of responsible fiscal stewardship, stable property tax collections, diversified economies, and limited exposure to current COVID-19 hotspots. Also, essential purpose revenue issuers responsible for water, sewer, power, and public safety projects also offer incremental yield and some insulation from the pandemic’s effects. State general obligation issuers with slim cash positons or large unfunded pension obligations warrant caution. On the revenue side, sales tax, hotel and convention center, real estate development, small university and healthcare revenue bonds are exposed to sector-specific risks that require either a high level of credit analysis or avoidance altogether.

Disclosures

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