- The Fed helped revive the muni-debt market as states and local governments grappled with revenue disruptions.
- Inflows and issuances have picked up as investors pile back into muni-bond funds and capital markets reopen.
- The greatest risk and reward for investors lie in lower-rated securities, in our view.
The municipal (muni) bond market is slowly recovering from a period of unprecedented volatility during the height of the coronavirus pandemic. Stimulus measures from the Federal Reserve and Congress have stabilized the market and increased liquidity. Since states began to gradually reopen in May and some economic indicators improved, prices essentially recovered, yields fell to below pre-pandemic levels, and inflows turned positive. Still, the muni market continues to grapple with the widening spread of COVID-19, possible renewed lockdowns, and budget shortfalls. We have a reasonably optimistic outlook, and we are dedicating credit research to what may be attractive opportunities in lower-rated tiers.
Fed’s muni-debt program provides lifeline
The Fed cut interest rates to near zero in mid-March and unleashed a torrent of bond-buying programs, including the Municipal Liquidity Facility (MLF). The announcement of the $500 billion emergency lending program for state and local governments in early April has helped municipal bonds recover from a record sell-off in March. But as state and local debt continued to struggle, the Fed in late April expanded the scope and duration of the muni program to some smaller cities. In August, the Fed said it would reduce the rates it charges cities and states seeking short-term loans from the MLF. This facility has not been heavily used except by a few low-rated borrowers.
Congress has also pumped trillions of stimulus dollars into the economy. The $2.2-trillion CARES Act provided relief for individuals, businesses, and hospitals, and set aside $150 billion in federal fiscal support for state and local governments. As funds from these programs wind their way through the economy, the medium-term economic outlook has generally stabilized, municipal bond fund flows have turned positive, and spreads (the risk premiums investors demand to hold these securities over U.S. Treasuries) have narrowed. These developments helped to support municipal bonds over the past few months.
Finding opportunities in uncertain times
The almost $4 trillion state and local government debt market — widely viewed as a safe-haven investment — has suddenly become one where assessing risk matters again. While defaults have remained relatively low compared with other markets, they have started to increase. In some states, such as Florida, California, and Texas, coronavirus infections had accelerated, weighing on the nascent economy recovery. Rising cases and further lockdowns impair tax collection, fees, and spending.
Even with coronavirus losses weighing heavily on state and city coffers, investors are piling back into municipal debt, hungry for yield, and are seeking more safety than the stock market can provide. Inflows into municipal bond mutual funds have continued. Defaults remain a small fraction of the overall municipal universe. Issuance also picked up in May and June as capital market conditions improved.
The yields on AAA- and AA-rated muni securities have fallen to pre-pandemic levels and are now near all-time lows, according to research by several Fed economists and analysts. Yields on lower-rated securities (BBB and, to a lesser extent, A) are still wider than pre-pandemic levels. As a result, the spread between lower-rated (A and BBB) and higher-rated (AAA and AA) municipal securities is still higher than it was in the first two months of the year.
On the credit spectrum, higher-yielding, lower-rated muni debt generally outperformed higher-rated securities during the second quarter. Medium-term securities outperformed long- and short-term maturity bonds. Revenue bonds outperformed general obligation bonds [GOs]. Within revenue-based bonds, we favor electric, water and sewer, and tobacco. Housing and special tax-backed bonds were the biggest underperformers. Although credit spreads remain wide versus average levels — particularly among lower-rated, high-yield muni debt, led by airline/airport and tobacco bonds — and some bonds are still yielding more than 100% of Treasury yields, the majority of the investment-grade muni cohorts have returned to more normal levels.
Keeping an eye on reserves
We believe state and local governments have ample reserves to prepare for potential revenue declines. Municipalities that lack these reserves may be able to balance their budgets using one-off measures, including reducing expenses and borrowing from the markets or the Fed’s MLF program. Some states and local governments can raise revenues by increasing taxes or fees. In our view, most states and local governments would only see prolonged fiscal stress should economic activity fail to stabilize over the next 12 to 18 months. Putnam’s deep credit analysts provide bottom-up, fundamental credit analysis on each bond we buy, allowing the portfolio managers to construct the portfolios with the team’s best ideas and strategies.
Much of the issuance within the municipal market is used to finance public infrastructure, which include toll roads, subways, bridges, ports, airports, colleges, and convention centers. It is critical that people be mobile and be able to congregate for these enterprises to generate revenue. Lack of mobility or severely reduced usage by the public could have trickle down effects on state and local municipalities.
The Fed has signaled it will hold short-term rates near zero until 2022. We believe the Fed stands ready to revisit nontraditional policy tools should the economy deteriorate further. The strength of this recovery and the pace of normalization will shape the performance of the municipal bond market in the months ahead. At this point, the greatest risk and opportunity are in lower-rated securities.
A sound market
We believe it will take time for the market to digest the longer-term impact of COVID-19. While we don’t see a systemic risk to the municipal market, we are seeing credit fundamentals broadly deteriorating. High-yield and lower-investment-grade credit spreads narrowed from their worst levels during the period but are still significantly wider than pre-pandemic levels. As the federal government considers additional support for municipalities, we believe that direct aid to states and municipalities is warranted and necessary given the challenges posed by the pandemic.
The municipal bond market has gone through quite a volatile 2020. And although we believe additional pandemic-related volatility could return, we also believe the municipal bond market remains sound and most borrowers will be able to weather this storm. We believe for long-term investors, the muni market overall remains a high-quality market with modest default frequency and a way for investors to capture tax-exempt income while diversifying their overall portfolios.
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