Jim Colby, Portfolio Manager and Strategist, Municipal Bonds
May 20, 2020
During periods of economic uncertainty, near-term decisions can determine the nature and durability of the recovery that drives long-term credit quality. I believe there is some cause for optimism for recovery in the municipal bond market. There may be many bumps in the road, but fears of many humpty-dumpty defaults really belong more in a story about Chicken Little.
My many years working with the municipal bond market entitles me, I suppose, to offer some perspective on what has occurred over the past two months, and what we might anticipate for the next few months. There isn’t anyone who has not, in one way or another, asked “What do I do next?” To frame some possible answers, here are a few “markers” to consider.
Extraordinary measures are being put in play by Congress to provide dollars to the general population to bridge some of the jobless gap and to provide some basis for economic stimulus.
The Federal Reserve (Fed) has prepared—but not yet launched—a support program, the Municipal Liquidity Facility (MLF), to provide liquidity to the municipal market, allowing muni borrowers to issue short-term cash management notes that the Fed will purchase.
March market volatility, the likes of which none of us have ever experienced, has receded to allow normalization of pricing and resumption of issuance now that we are into the month of May.
Cumulative outflows, reflected in redemptions from mutual funds and ETFs, have dropped by 70%1, suggesting that there is less of an emotional component to investing and a return to comparative opportunities which drove investing patterns 6 to 12 months ago.
These observations are, in and of themselves, touching important elements as to the restoration of economic and marketplace confidence. I cannot predict the path or duration of COVID-19, but it is certain to disrupt economic activity – everywhere. Its impact will be upon each entity that issues bonds for public improvements and purposes, to some greater or lesser degree. The bad news is that we cannot predict the impact everywhere. But the good news is that, owing to the structural requirements of bond financings in the municipal space, issues that carry ratings from Moody’s, S&P and Fitch not only build reserves into each financing, but the ratings that are achieved are done so based, in part, upon the concept of “rainy day” reserves set aside by the issuer to meet contingencies such as what we are now witnessing.
The municipal industry has a long history of very strong credit quality and very low default experience. Though credit quality will be reviewed and tested in the months to come, these points will be important to note as investment decisions are made going forward:
After the events of the financial crisis in 2008, the ratings agencies will be quick to address any concerns for changing their credit outlook on all issuers.
The MLF aims to keep the marketplace active and efficient, allowing issuers access to capital while their economies or programs begin to return to normalcy.
With any downgrades in credit quality, spreads between maturities, ratings and sectors are going to widen, potentially providing more compensation to the investor for the changes that occur. Currently, with Treasury rates remaining at very low levels, opportunities for value trades in municipals – especially investment grade – are prominent. I believe the value of the tax-exempt coupon is still significant.
During this recent period of instability, I would point out that the structure of the ETF has held up. It stood the dual tests of providing liquidity as well as stability of valuation, benefitting from their highly diversified structure.
All things considered, while we expect some bumpy roads in the near-term, I am optimistic about the municipal bond market’s recovery. The attributes that have historically contributed to the strength of this market are still there and may factor into its recovery.
1 Source: JP Morgan. Data as of May 13, 2020.
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Portfolio Manager and Strategist, Municipal Bonds
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