The municipal bond market’s response to the COVID-19 pandemic reflects the significant dislocation to our economy, the financial markets and, of course, our personal lives.  The municipal market hit a rough patch in March 2020, selling off with a velocity not seen in decades. Over the past month, municipal volatility surged and credit spreads widened.

If there’s any silver lining for municipal bond investors, it’s that times like these create rare total return opportunities for experienced, professional investment managers. Below, we recap what’s transpired in the investment grade municipal marketplace and how to put this in perspective.

 

What Went Wrong?

Municipal bond mutual funds enjoyed six consecutive years of positive net inflows, culminating with 2019 when funds took in a record-breaking $96 billion in net inflows, the largest single amount in a calendar year dating back to 1992, when Lipper began tracking flow data.

  • The SALT deduction limit of $10,000 was perhaps the most significant driver of recent demand, especially from investors in high tax states.
  • High demand resulted in:
    • Significant spread tightening and AAA rated municipal/U.S Treasury yield ratios reaching all-time lows, as shown in Figure 1. Keep in mind that ratios alone are not very informative in the current environment where U.S. Treasury yields are approaching 0%, a point we’ll revisit shortly.
    • Bloomberg Barclay’s longstanding Municipal Bond Index yield to worst dropping to 1.14% on March 9, 2020, its lowest level in 40 years.

AAA municipal bond yields increased by nearly 200 basis points across the yield curve (Figure 2).

The municipal bond market was not spared during the current COVID-19 health crisis and market panic.

  • The municipal market experienced a dramatic technical sell off during which participants sold municipal bonds across all sectors, credit quality buckets, and maturity ranges indiscriminately (i.e. without regard for price execution).
  • AAA municipal bond yields increased by nearly 200 basis points across the yield curve (Figure 2).
  • Municipal bond mutual funds saw record 1-week outflows of $12 billion and $14 billion for the weeks ending 3/18/2020 and 3/25/2020, respectively, reversing municipal bond funds into net outflow territory, YTD (source: Lipper, as of 3/31/20).
  • This was exacerbated by the lack of two-way committed capital in the municipal market. Bond dealers were simply not able to step in and absorb the large amounts of dollars coming out of funds. Dealer inventories have downsized materially over the years following the 2008 financial crisis (Figure 3).

When the dust settled, the Investment Grade Municipal Index (ICE BofA U.S. Municipal Securities) ended the month of March down  -3.75%, certainly not great for a relatively staid asset class, but not bad when taking into consideration that at one point in March the Index was down as much as -11.4%. The Bloomberg Barclays Index yield followed a similar trajectory, coming off its March 9 low and hitting 3.52% by March 23, finally settling in for the month-end at 2.01%. While not a focus of this writeup, the high yield municipal market was subject to a greater degree of illiquidity and forced selling.  The Bloomberg Barclays High Yield Muni Index returned –11.0% for the month of March.

 

Figure 1. 10-Year AAA Municipal/U.S. Treasury Yield

Source: Bloomberg Barclays, as of 3/31/2020. 10-Year Muni/Treasury Ratio is the ratio of the yield to maturity of a generic 10-year AAA municipal bond to the yield to maturity of a generic 10-year U.S. Treasury note.  Past performance is not indicative of future results.

 

Figure 2. AAA muni yields increased across the curve by nearly 200 bps (2%) in a matter of days

Source: Bloomberg Barclays, as of 3/31/2020. The above reflects the yield-to-maturity over time of generic 2-Year, 5-Year, 10-Yr, and 30-Yr AAA rated municipal bonds Past performance is not indicative of future results.

 

Figure 3. Declining broker-dealer inventories indicate heightened liquidity risk

Source: U.S. Federal Reserve, as of December 2019.

 

Historic dislocations have created opportunities

Looking at daily Index data (ICE BofA ML U.S. Municipal Securities) going back to December 1992 (Figure 4), we note the following:

  • Four of the top ten biggest daily increases in the Index’s yield to worst (YTW) occurred within a 9-day span in March 2020 (bond yields and prices move in opposite directions).
  • This is incredibly rare for investment grade municipals. Yields have never moved so sharply and in such a condensed timeframe.
  • As shown in Figure 5, sudden dislocations are also rare and sometimes fleeting, like in March 2020, where yields compressed back towards equilibrium as quickly as they had risen.
 
 

Figure 4. Index yields rarely see large double-digit increases in a single day

Source: ICE BofA ML U.S. Municipal Securities Index, as of March 2020.  Past performance is not indicative of future results. An investment cannot be made in an index.

 

Figure 5. Large single day double-digit decreases in yield are just as rare.  Note how rapidly yields compressed on three dates in March 2020

Source: ICE BofA ML U.S. Municipal Securities Index, as of March 2020. Past performance is not indicative of future results. An investment cannot be made in an index.

Looking at the many sectors within the ICE BofA ML U.S. Municipal Securities Index, it becomes clear that the entire IG municipal market went on sale during this historical bout of volatility (Figure 6).

  • Many sectors that carried yields in the 1% range at the end of February 2020 now carry yields in the 2% range and higher. The average increase, MoM, was +0.79%.
  • Some sectors and pockets of credit may be better poised for a quicker recovery than others while others could face additional headwinds.
  • We believe that due diligence and deep credit research will continue to be critical, underscoring the value that an experienced and skilled professional manager can bring to the table by expressing views via sector, credit, and yield curve positioning.
 

Figure 6. Yields increased in every IG sector, indicating indiscriminate selling (sorted by increase in YTW)

 

Source: ICE BofA ML U.S. Municipal Securities Index, as of March 2020. Past performance is not indicative of future results. An investment cannot be made in an index.

 

Relative Value Has Returned

In the current environment, using the classic AAA muni/Treasury ratio as a gage for measuring relative value may not be sufficient enough. Municipal yields increased by roughly 200 basis points across the AAA curve, while on the other hand U.S. Treasury yields plummeted to near zero. The result is ratios that are distorted, significantly blown out well above long-term norms.  This is not very informative as a stand-alone metric given the above point regarding Treasury yields.

From the relative value point of view, consider comparing munis to comparably rated corporates. Accounting for the value of tax-exemption, municipal bonds recently offered significantly more compelling yields relative to corporates compared with the end of February 2020 (Figure 7)

 

Figure 7. Tax-Equivalent Yield Spreads Over Corporate Bonds Have Become Attractive

Source: ICE BofA U.S. Municipal Securities Index, as of March 2020. Tax-equivalent yield based on 40.80% tax level (37% highest federal tax bracket plus the 3.8% Medicare surcharge).  Past performance is not indicative of future results. An investment cannot be made in an index.

 

Concluding Thoughts

  • Historically, municipals rarely had bouts of volatility like they experienced in March 2020.
  • Keep in mind that this continues to be a fluid situation, but, we do not believe that the investment grade municipal market is at risk to the same forced-selloff overhang seen in the high yield municipal market.
  • As a result, we anticipate a faster recovery in investment grade municipal bonds, and as of this writing prices and yields had started to gravitate back in the direction of longer-term norms.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

Municipal bond risks include the ability of the issuer to repay the obligation, the relative lack of information about certain issuers, and the possibility of future tax and legislative changes, which could affect the market for and value of municipal securities. A portion of a fund’s income may be subject to state and local taxes or the alternative minimum tax. Income from municipal bonds held by a fund could be declared taxable because of unfavorable changes in tax law, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. High-yield municipal bonds may be subject to increased liquidity risk as compared to other high-yield debt securities. Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.

Credit ratings: Moody’s rates borrowers on a scale from Aaa through C. Aaa through Baa3 represent investment grade, while Ba1 through C represent non-investment grade. Standard & Poor’s rates borrowers on a scale from AAA to D. AAA through BBB represent investment grade, while BB through D represent non-investment grade. Fitch rates borrowers on a scale from AAA to D. AAA to BBB represent investment grade, while BB through D represent non-investment grade.

Yield to Worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting. The YTW is calculated by making worst-case scenario assumptions on the issue by calculating the return that would be received if the issuer uses provisions, including prepayments, calls or sinking funds. This metric is used to evaluate the worst-case scenario for yield to help investors manage risks and ensure that specific income requirements will still be met even in the worst scenarios.

Yield to Maturity is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate.

ICE BofA ML U.S. Municipal Securities Index tracks the performance of large capitalization U.S. denominated investment grade tax-exempt debt publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. domestic market.

Tax-equivalent yield is the yield that would be required on a taxable security to provide the same yield after taxes as is provided by a tax-exempt municipal bond. The higher a person’s tax bracket is, the higher the tax-equivalent yield will be. Tax-equivalent yield is often used when evaluating municipal bonds.

Neither New York Life Investment Management LLC, nor its affiliates or representatives provide tax, legal or accounting advice. Please contact your own professionals.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

Not FDIC/NCUA Insured. Not a Deposit. May Lose Value. No Bank Guarantee. Not Insured by Any Government Agency.

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