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Municipal markets: signs of healing, challenges and opportunities
How have municipal bonds been performing?Credit markets improved this week, in line with better stock market performance. Global financial markets, including municipals, have started pricing in a likelihood that federal government support will provide some downside protection to the economy, while the Federal Reserve (Fed) works to improve liquidity conditions in the credit markets.
Importantly, municipal yields declined on Tuesday, 24 March for the first time since 9 March. Tuesday’s recovery marked the biggest one-day rally in at least nine years. An exuberant market followed through on Wednesday and Thursday, pushing the cumulative price advance of the last three days to more than 6.5% on average. This move was large enough to erase a significant portion of the losses of the first two weeks of March.
Improvement was broad-based across the municipal market, although higher quality bonds led the way. These investment grade bonds make up 90% of the market, and could eventually benefit from an expanded Fed bond purchase program.
Since the end of February, the 10-year Treasury yield has declined by 25 bps, while the 10-year AAA municipal yield increased by 51 bps. These moves have doubled the municipal-to-Treasury yield ratio from 82% to 164%. For the same time period, the 30-year Treasury yield is down 20 bps and the 30-year AAA municipal yield is up 100 bps, moving that ratio from 92% to 174%. These ratios appear irrational given municipal fundamentals, tax benefits and historical relationships to Treasuries.
We believe these ratios should correct themselves once investors feel more confident about the effect of the federal government’s stimulus bill, and see more clarity around the coronavirus outbreak. As such, we think volatility will remain high, but we expect further price recovery in municipal bonds over the intermediate term.
Is liquidity still strained?We are already seeing improvement in overall liquidity conditions. Outflows have been very high for two weeks, but already show signs of slowing, and flows could turn positive over the course of the next few weeks. In the meantime, while fund flows potentially recover soon, liquidity is coming from crossover buyers, bank portfolios, insurance companies, hedge funds and opportunistic buyers looking for value.
Compared to 2008, this is a much faster developing crisis that could bounce back quicker, as we are beginning to see. The financial system as a whole is much healthier today, including issuers of municipal bonds. Liquidity remains stretched, but it is improved compared to the first three weeks of March.
Will fiscal and monetary stimulus help settle the municipal market?The stimulus package working its way through Washington, D.C. offers both direct and indirect benefits for municipal bonds. Some of its components are directed toward fundamental credit support, while others are geared toward liquidity. The Care Act (Coronavirus Aid, Relief and Economic Security Act) is expected to be passed by the House on Friday, 27 March.
In its current form, it will provide credit stabilization by authorizing the U.S. Treasury to pay $150 billion to state, local, tribal and territorial governments this year to cover necessary expenditures incurred due to the coronavirus crisis that were not previously accounted for in their budgets. In addition, the Care Act enables the Treasury to make loans directly to passenger air carriers ($25 billion), cargo air carriers ($4 billion) and businesses essential to national security ($17 billion).
The legislation also provides liquidity benefits by authorizing $454 billion of direct loans and loan guarantees from the Treasury to corporations and municipalities. This, in turn, supports the new Fed initiatives.
The Fed has been extremely active during this rapidly unfolding crisis. Less than two weeks ago, it cut short-term interest rates to near zero, while simultaneously announcing a Treasury bond purchase program ($500 billion) and a mortgage bond purchase program ($200 billion).
With the Care Act authorizing $454 billion of direct lending from the Treasury, it is widely anticipated that the Fed will make this the foundation for a 10x ratio for bond purchasing in the corporate and municipal bond markets. This would give the Fed more than $4 trillion of new purchasing firepower to narrow spreads and improve liquidity in these credit-spread-driven markets.
The Fed’s goal is to reopen the market for new issues while lowering borrowing costs for corporations and municipalities. We believe the combination of the Care Act, Treasury Department actions and Fed initiatives should constitute a meaningful tailwind for the municipal market.
Fed programs are also continuing to help stabilize short-term markets. Variable rate securities, including municipals, are being added back to bank balance sheets as individuals and businesses stockpile cash. This has temporarily increased short-term municipal rates at a time when the Fed is attempting to push interest rates lower.
A solution to this trend was put into place on Friday, 20 March. Specifically, these short-term variable rate municipal notes can now be used as collateral for banks to borrow at the Fed’s discount window for a rate of just 0.25%, which should also reduce municipal short-term yields. While only in place for one week, this program has already significantly reduced short-term municipal yields.
Investors are viewing the pending stimulus bill positively, as we have seen stock prices rise and credit spreads narrow over the last few days. Markets have gained confidence that the federal government is aggressively lending support through this unprecedented time, which is improving sentiment.
Where is the opportunity amid the turmoil?It is too early to determine how the economic downturn will affect municipal credit quality. While we expect some credit pressures on state and local governments, credit health is highly idiosyncratic. Some general obligation bonds, such as New York City and Chicago, have more tools and financial flexibility, and will likely be more resilient. They will also stand to benefit more directly from fiscal stimulus. Within revenue bonds, areas like airports have rebounded strongly this week on anticipation of federal support. Other industries will see more pressure, such as senior living facilities.
We see opportunities across the municipal market, including high yield. Just weeks ago, the asset class was in short supply versus robust demand, and fundamentally sound. These price dislocations have been extreme, based on technicals and liquidity pressures. Any hints of positive news about the virus control or improved financial conditions could potentially trigger additional price jumps. As we have been saying for the past couple of weeks, credit selection remains critically important and opportunities remain highly specific, suggesting the need for careful active management.
The case for municipals today: solid fundamentals backed by large monetary and fiscal stimulus efforts and extraordinarily high yields compared to taxable bonds, especially Treasuries.
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.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
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.