What has happened in municipal bond markets
Perspectives on municipal bond market volatility
MONTHLY MARKET COMMENTARY |
Contrary to its role as a source of stability in investor portfolios, high-quality municipal bonds have experienced a sharp sell-off in recent days. Heavy selling of liquid assets has rippled across financial markets.
The bout of sales caused a large move upward in municipal yields, rising approximately 120-140 basis points (bps) or 1.2%-1.4% across the yield curve between March 13 and March 20, 2020.1 As a result, the Bloomberg Barclays Municipal Index fell -6.57% for the week and -10.32% for the month ending March 20, 2020.2
With U.S. Treasury yields grinding lower, municipal-to-Treasury yield ratios (i.e., yield on municipal bonds compared to yields on similar maturity Treasuries) have suddenly risen to historic levels.
What is causing the sell-off?
We believe the sharp sell-off in municipal bonds reflects a mismatch in market liquidity rather than a signal of looming financial stress or credit weakness in municipal finances. For the first part of 2020, municipal market performance was strong, reflecting healthy fundamentals. However, as the coronavirus crisis deepened, investors feeling liquidity pressure started withdrawing money from municipal bond funds.
Municipal bonds and funds are typically held by individual investors rather than large institutions. These are the same investors facing stay-at-home ordinances, and facing work stoppages and uncertain cash flows, potentially prompting a desire to have cash absent paychecks. As a result, municipal bond mutual funds endured outflows totaling $12.2 billion in the past week, after $4 billion in outflows the prior week. This was the largest weekly outflow from municipal mutual funds since Lipper began reporting the data in 1992, and nearly two times larger than the previous weekly record of $6.9 billion of outflows set in 2013.
The last time the market experienced this kind of negative flow was during the financial crisis, when over a 41-consecutive-week period the asset class incurred approximately $50 billion in outflows.3 This magnitude of outflows has led to significant spread widening. For example, where the previous largest single-day move in spreads was 0.28% in 2008, this past week experienced a day where rates moved 0.50%. This volatility has also influenced the new issue market, and the lack of new supply has put further technical pressures on markets.
In addition to the heavy selling mentioned above, disorderly trading in the Treasury market made it nearly impossible for dealers and other non-traditional buyers of municipal bonds to hedge their investments, weakening their bids for bonds they feared they could end up holding in inventory. Additionally, a crossover bid that usually emerges in the market when municipal bonds are selling off may have found better opportunities in markets that also cratered recently, such as equities or corporate bonds. It is important to remember that liquidity is poor across the Treasury, corporate bond and mortgage-backed markets, and is not just specific to municipals.4
What is our outlook and guidance?
Sharp, rapid declines in an asset class intended to provide stability and risk mitigation are understandably disconcerting, yet even lower-risk assets can have temporary dislocations in stressful, emotionally charged periods. While economic fallout from COVID-19 will most certainly have an impact on municipal budgets and cash flows, we believe recent negative performance in the investment-grade market is technical (and temporary) in nature, and has been driven by low liquidity more than credit concerns or weakening municipal finance fundamentals.
Before the coronavirus crisis hit, municipal credit health was in some ways at its strongest since the financial crisis. Municipalities still have ample cash, have been experiencing credit upgrades and enjoy solid revenue growth.5
This health crisis is an exogenous shock, similar to a natural disaster. Municipals have been resilient through other such shocks and periods of extreme economic stress due to their importance in the day-to-day functioning of our society. In our view and that of the municipal bond managers we speak with, overall credit health remains solid for municipal issuers.
Consequently, we do not advocate abandoning high-quality municipal bond allocations, particularly during a period of heightened liquidity stress, where prices received likely will not reflect fundamentals. In fact, while yields on municipal bonds have moved sharply higher, U.S. Treasury yields have moved lower. As a result, municipal-to-Treasury yield ratios have suddenly risen to historic levels. This may represent an opportunity for long-term investors building fixed income allocations.
What are some potential catalysts for stability?
The Federal Reserve (Fed), Congress and the Treasury are acting quickly to provide liquidity broadly to credit and money markets (although the effects of the programs may operate with a lag). As a result, the municipal market continues to have a negative tone, particularly in shorter maturity areas.
The Fed and other policymakers have made it clear they will do what it takes to promote broad market liquidity; we think these policies will eventually help to stabilize the markets and restore liquidity.
Specifically, new lending operations announced on March 23 follow the creation of three programs unveiled the prior week. The first program aims to unclog dysfunctional markets for short-term corporate IOUs called commercial paper. The central bank said the Commercial Paper Funding Facility would also be open to include high-quality debt issued by municipalities.
A second program launched last week allows approved dealers of U.S. government debt to borrow against some stocks, municipal debt and highly rated corporate bonds. This reduces the pressure to offload municipal bonds in favor of Treasury collateral.
A third program seeks to prevent runs on money-market funds, which investors generally treat as safe as cash. The Fed expanded this program to include certain municipal money market funds on Friday and, on March 23, said it would include a wider range of securities, including municipal variable-rate demand notes and bank certificates of deposit.
While volatility may remain higher than normal, we do expect the actions above to help ease liquidity tightness and restore normal functioning trading.