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Municipal market volatility: opportunities within the crisis
What’s been happening in the municipal bond market?For the first couple of months of the year, municipal bonds benefited from strong fundamentals, attractive supply/demand dynamics, solid credit conditions and low interest rates. Performance in this market had been strong, and valuations had become relatively rich.
As the coronavirus crisis deepened, and as investors began moving out of stocks and other risk assets into the perceived safety of Treasuries, municipal bonds initially followed Treasuries as part of the flight to quality.
That began to change over the last couple of weeks, when investors (particularly U.S. individual investors) began feeling liquidity pressure and started to withdraw money from municipal bond funds, which hurt both the high grade and high yield sectors of the market. The resulting price decline was swift, and in some cases may have been exacerbated by selling pressures in ETFs and closed-end funds.
Last week marked the first in the last 60 that municipal funds saw outflows rather than inflows as a result of this selling. Given the trend in flows and current price weakness, many investors are now questioning the fundamental health of the municipal bond market, which we’ll cover in the following questions.
What is the state of liquidity within municipals?Liquidity is still available in the markets—but at a higher yield. Given the state of panic that many investors are experiencing, liquidity of any sort is trading at a premium. In our view, municipal markets are in the midst of a technical mismatch. Having said that, today’s lower prices and higher yields are already starting to correct this mismatch. Fundamentals have not changed for most municipalities around the country—what has changed is investor sentiment.
In other words, we don’t believe municipal bond prices today reflect fair value. In the near-term, supply/demand technicals may drive performance while the bottoming process unfolds and until coronavirus-related risks subside. When that happens, we expect investors will begin returning to a focus on fundamentals, which should be a positive for municipal markets.
Speaking of fundamentals, what is the current credit health of the municipal market?In general, municipal bonds tend to be high quality and defaults are rare. Most municipal issuers provide essential services and generally have a long history of functioning through varying economic cycles, credit cycles and temporary disruptions. And before the crisis hit, municipal credit health was very strong—in our view, the strongest it had been since the financial crisis. Municipalities still have ample cash, have been experiencing credit upgrades and enjoying solid revenue growth. The good news is that municipal credit health is starting from a strong position.
However, we do think that the coronavirus will have a more significant negative effect on some municipal sectors. Senior living-related and continuing care retirement community (CCRC) bonds could come under increased pressure as prospective residents and their families will likely delay entry into senior living facilitates when care is not essential. Healthcare bonds could also experience a mixed temporary impact, and we expect to see negative effects on airports, airlines and issuers like convention centers as people avoid travel and large gatherings. But even in these cases, we are not expecting to see serious, widespread long-term credit deterioration or defaults. Careful credit research and analysis will still be critical to identify attractive areas of the market.
How should investors approach municipal markets during this time?The bottom line is we do not think this is a time for investors to panic and make changes to their long-term allocations. For those investors who were incorporating municipal bonds into their portfolios for their income, relative yield, total return and/or tax-related objectives, we think they should stick with their plans. This is not a time to move to cash. Riding out periods of volatility and market dislocations is always painful, but it is exactly for these sorts of times that long-term plans are made.
At the same time, we never suggest trying to time market bottoms, but it is worth pointing out that the price moves over the last couple of weeks have created some value within municipal markets. Given the relative rise in yields and expanding of credit spreads, municipals now look very inexpensive compared to Treasuries. And, in fact, we have started to see so-called crossover investors (institutional and non-U.S. investors) purchasing municipals at lower prices over the past couple of days. Over time, we expect to see U.S. individual investors (who make up the bulk of purchasers of bond funds) also recognize this relative value.
What is the outlook for the market?As we indicated previously, municipal market fundamentals have not changed. We are not seeing inflation pressures, the Fed is in the midst of a rate-cutting campaign (and will likely ramp up asset purchases in the coming weeks to include agencies and mortgage bonds) and credit fundamentals remain solid for most municipalities. All of these factors should provide tailwinds for municipals over the long term.
Over the immediate term, we think market volatility will persist in municipals and across global financial markets. But, as we previously stated, the recent price declines and widening of credit spreads has created compelling value. At present, it feels to us like the market is at the start of building a new base of demand for municipal bonds at these lower prices. The selloff has been rapid and sharp, and the outlook is mixed, but we place trust in our long-term focus on fundamentals.
In particular, we think higher-quality, longer-duration areas of the municipal market look attractive and could be the first to snap back when investors return to a focus on fundamentals. Additionally, we are seeing value in the high yield municipal space where spreads have widened dramatically without a corresponding increase in defaults or credit downgrades.
Bottom line: We think most municipal issuers should be able to weather this storm and believe that municipal bonds continue to offer attractive yields and credit resilience.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
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A word on risk
Investing involves risk; principal loss is possible. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments. This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen, LLC. Nuveen provides investment advisory solutions through its investment specialists.