Municipal managers who witnessed the most harrowing days in the tax-exempt market during the COVID-19 crisis are taking advantage of attractive spreads in sectors most impacted by the pandemic — even now that the climate has stabilized.
While they haven’t abandoned the high-quality, defensive, and relative value-based strategies and objectives they employed before the pandemic, they are finding value in select, higher-yielding securities that experienced price dislocation earlier this year.
“With credit spreads wider, we have taken the opportunity to put more credit spread into the funds and will continue to look for more attractive entry points,” said Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income.
Barber is currently finding those opportunities in several of the traditional municipal sectors, such as state and local general obligation bonds, transportation, and healthcare.
“Higher-quality healthcare systems, airports and municipal bonds that might be secured by a high-grade corporation offer value,” Eric Fischer managing director and client development officer in the Global Capital Markets division at Wilmington Trust in Boston, said.
The managers are being extra diligent and wary of potential yield, credit, and sector risks, looking at the market with a keener eye and being observant of any potential credit obstacles ahead.
Though Barber largely maintains the same value investing strategy along the curve and credit spectrum he favored before the COVID-19 crisis, he has also found value lately under pandemic market conditions, such as poor liquidity.
In general, liquidity gets worse,and opportunities get better, further out on the yield curve, and lower down on the credit spectrum, according to Barber.
“It keeps the asset class cheaper on a relative basis than it probably should be, given the overall high credit-quality of the municipal market,” he said.
This is especially true in a long-only market with no way to effectively hedge either duration or credit risk, he noted.
That phenomenon caused the municipal market to dislocate versus the Treasury market back in March, Barber pointed out.
“As news of COVID-19 spread and shelter in place became a reality, the general ‘risk off’ sentiment that followed affected most asset classes, including high-quality municipal bonds,” Barber said.
Since then, the market has stabilized compared with the March and April sell-off and subsequent redemptions and underperformance versus Treasuries, he noted.
“May has brought stability to flows and many sectors within high-quality munis have bounced back significantly,” Barber continued, noting that delivering high levels of tax-exempt income to clients through high-quality and long-term strategies remains his prime focus.
“The muni market shifts constantly, and we remain vigilant in our credit research and portfolio management process,” Barber said.
Sylvia Yeh, co-head of Goldman Sachs Asset Management’s Municipal Fixed Income Business, is also making adjustments in the yield portion of their business based on changing views of sector-specific risk.
She said the firm has identified some risk-reward opportunities in COVID-19 impacted sectors, as well as in the triple-B space.
“The triple-B part of the market has lagged the snapback that we have seen in higher-grade space — despite the fact that on a historic basis actual default risk in triple-B bonds is extremely low,” she said.
In addition, those medium-tiered single-A and triple-B bonds are currently trading at spreads near historic highs as limited trading and price discovery continues.
For that reason, she said individual credit selection is key.
Yeh is among those managers who are keeping their overall pre-pandemic strategies in place, since the underlying credit fundamentals of the municipal market haven’t changed, she said.
Overall, she aims to provide a defensive and highly rated portfolio with a steady tax-efficient income stream to individual investors, while avoiding unnecessary risk.
“For conservative investors who consider their muni bonds the sleep well and sound portion of their asset allocation, we feel strongly that this is not the time to stretch and take unnecessary risk — especially risk that is not appropriately priced,” Yeh said.
However, Yeh is making minor adjustments where necessary.
“We are taking a somewhat modified approach to sensitivity modeling where appropriate,” she explained.
“It’s not business as usual in the yield space, however, we see some better value opportunities today than before the huge dislocation in March-April,” Yeh said.
Meanwhile, Barber said adapting to the market’s challenges and changes due to the COVID-19 pandemic will impact strategy and analysis going forward while also creating opportunities.
While strong liquidity can currently be found in much of the high-grade market, the lower-quality sector is still experiencing price discovery, Barber explained.
Fischer said a sudden drop in revenue sources affect all municipalities, but mostly those that rely on dedicated sources, like sales taxes, gas taxes, and user fees.
The securities are tied more directly to sectors such as airports and ports, transportation and toll roads, healthcare and hospital systems and higher education, or lower-rated credit with less financial flexibility and thinner balance sheets, Fischer said.
He said those credits will be more affected by the decisions consumers and users make during recovery from the pandemic.
Barber agreed, saying that there are real structural changes to the way that people use services financed with municipal bonds, and the market will scrutinize certain credits more heavily going forward.
“As an example, the higher education model is going through a massive change to its historical structure, not just the universities themselves, but also student housing, some of which is financed separately from university financing,” Barber said.
Consequently, the market is being extra diligent and wary of potential yield, credit, and sector risks, and this means more need to monitor credit outlooks for potential problems ahead, managers and analysts said.
The market has seen dramatic changes to the transportation sector, as well as airports, toll roads, and bridges, according to Barber.
“These are sectors and individual securities that will have to be analyzed with a new lens in today’s environment,” he said.
“We’re evaluating the impact of the virus, assessing risks and determining value,” Yeh agreed.
“There are certain sectors that may not be appropriate for specific investors and/or investment vehicles while they may be interesting for others to consider,” Yeh added.
Fischer of Wilmington said the changes mean credit is more vital than ever.
“There are 50,000 issuing entities across the U.S. that issue municipal bonds, so the value of individual and sector analysis is critical for managers to add value for clients in an asset class where preservation of capital is key,” he said.
“Understanding the trajectory of COVID-19 across the region, states and in different individual credits is important in the analysis,” Fischer added.
In the meantime, Yeh said the high-grade portion of the market is well supported as evidenced by an over two week rally in triple-A yields tracked by Refinitiv Municipal Market Data in late May.
“We believe in the underlying strengths and characteristics of the high-grade portion of the market — even in places where COVID-19 impact has been greatest, such as New York credits,” Yeh said, noting she remains positive on New York credits.
Investors are more cautious about credit whether the concerns are real or the result of headline risk, according to Yeh.
“That is why the lower-rated investment-grade, and high-yield parts of our market have been slower to bounce back,” Yeh said.
While there have been more triple-B and lower-rated deals issued and oversubscribed for, secondary trading activity has also increased with a tighter bid-ask spread, Yeh noted.
In addition, high-yield outflows have stopped, which is the underlying driver of the improved tone, she said.
However, the interest rate forecast remains uncertain, adding to the overall volatility, Yeh said.
Lower rates are a possibility if the market isn’t expecting a quick economic recovery, she said. However, a quick recovery could bring with it a higher rate environment in the near term, which investors would welcome, Yeh said.
“Portfolios can be traded to manage through a rising interest rate environment, restructuring positions in an effort to maximize future income streams,” she added.
With the market undergoing much transformation during and after the pandemic, the managers advise investors to find a comfort level, take advantage of buying opportunities when and if possible, and maintain a long-term horizon.
“Be patient. We do not expect there to be wide-spread defaults in the investment-grade municipal space,” Yeh said, adding that “not all munis are created equal” and that investors should seek guidance in the changing market.
“The days of buying and selling munis on your own is long gone. Market access has evolved and can be cumbersome,” noting that the asset class is returning to a credit market.
“Exposure to the muni market, today more than ever, should be achieved through professional management with a strong research team,” Yeh added.
Fischer said clients should continue to discuss their portfolios with their managers to make sure the investment teams are on top of the credits they cover.
They also need to factor “the possibility that this virus could return or a vaccine is a litter farther off than expected, affecting the economy and the investment markets,” Fischer said.
Barber, meanwhile, said the municipal market currently offers “very strong value” relative to other fixed income classes and that individuals should know their investment objectives and limits.
“Each investor will differ in terms of their risk appetite, so it’s crucial that they strike the right balance of interest rate and credit risk volatility for their needs,” he said.
Yeh said her portfolios are positioned to take advantage of potential opportunities in the remainder of 2020.
“We believe that there will be opportunities in certain sectors throughout the next few months, whether presented as a result of forced selling or a change in credit profile,” she said.
