March 20, 2020

What Happened

Over the past two weeks, tax-exempt Municipal bonds (Munis) have endured significant price weakness, with yields spiking more than 200 basis points (2%) across many parts of the AAA Muni curve. Strong, urgent selling pressure, particularly from individual or ‘retail’ investors, overwhelmed the pool of willing Muni buyers. Municipal bond fund managers became forced sellers of their funds’ underlying bonds as their clients sought immediate withdrawals. The liquidity—or the ease with which one can exit a given position or market—fell dramatically in the Muni space. Municipal bond yields are still rising even as the US Treasury market is discovering more solid footing. That has pushed Muni-to-US Treasury ratios (i.e., the yield offered by a Municipal bond relative to a US Treasury bond with a similar maturity) to all-time highs. These historical measures help put the sheer magnitude of the liquidity strain in context.

Our Take

Investors who typically look to their Municipal bond portfolios for stability are using these instruments to raise cash in the face of mounting uncertainty around the coronavirus (COVID-19) pandemic. The number of willing buyers has been very thin over the past two weeks as many face their own liquidity constraints. The decline in liquidity created a negative feedback loop that sent Municipal bond prices significantly lower. Many sellers approached the market with a singular mindset: sell now, ask questions later. As a result, AAA-rated Muni-to-US Treasury ratios are north of 2.5 between 1-5 year maturities. Two-year AAA Municipal bonds offer more than 2.0% higher absolute yields than two-year US Treasury notes, despite Munis’ potential tax benefits.

Today, the US Federal Reserve announced that its newly created Money Market Mutual Fund Liquidity Facility will allow the Fed to purchase shorter-dated Municipal bonds. This, along with the numerous other liquidity facilities the Fed resurrected recently from its financial crisis playbook, should help alleviate some of the liquidity constraints in the front end of the Muni curve. Therefore, we expect these dislocations in high-grade Municipals to slowly improve. That would help bring Muni-to-Treasury ratios toward healthier levels, which typically hover near 1.0.

Bottom Line

Thus far, the severe dislocation in the Muni market has been primarily driven by the sell-at-any-cost mindset that has plagued high-quality fixed income markets. The COVID-19 impact will undoubtedly pressure state and local government budgets due to lost tax revenue and the expense of launching a multi-faceted response to the virus. The severity of that impact is largely dependent upon containing the virus as swiftly as possible and decisive federal financial support.

For longer-term investors willing to accept risk, we believe there are emergent opportunities in high-grade Munis. We recommend investors maintain a high-quality allocation and emphasize general obligation issuers with ample reserves and investment grade essential purpose revenue bonds (i.e., water and sewer, power providers).

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CN2020-0693 EXP12-2020