Unrelenting demand, strong technicals will keep munis afloat during coronavirus
Despite low yields and scarce supply in the municipal market, robust demand is expected to continue with strong technicals and amid the ongoing COVID-19 climate for the remainder of the second half of 2020.
“There appear to be fewer bonds available for purchase and lighter bid-wanted activity,” Christopher Brigati, head of municipal trading for Advisors Asset Management, said.
“This lighter supply environment is also impacting the market and is expected to continue as we head into August,” he added.
In addition, a fairly consistent tightening of credit spreads continues as demand remains strong, Brigati said.
“As a barometer for retail sentiment, mutual fund flows have been positive for 11 straight weeks since the outflows experienced as a result of the COVID-19 concerns,” he said.
There is pressure to continue to put cash to work, which has caused municipal ratios, as a percentage of U.S. Treasury rates, to fall to the lowest levels since early March, Brigati noted.
“The market has rebounded strongly since the meltdown in March, and hopefully investors have learned some lessons about the illiquidity of the market in such situations and can better weather such storms in the future with proper planning,” Brigati added.
Among the strategies investors are employing, Brigati said they tend to reach for yield when the market feels stable and seek ways to enhance portfolio yields by extending duration and/or moving further out the credit curve.
That strategy is currently a challenge, however, as demand continues to be heavy, Brigati said.
Others, meanwhile, say the current market strength is a signal for investors to be cautious on credit and avoid risk.
Strong technicals and continued low rates prompted July to end with a rally, and investor demand remains healthy and thriving, said Ashton Goodfield, head of the municipal bond department at DWS Investment Management Americas Inc.
As investors seek out yield and supply, some managers, like Goodfield, say credit is key in the current market environment, and suggest investors focus on high-grade paper for its low risk of default.
“Investment-grade municipal credits have proven their resilience over many crises, and we expect that to continue,” she said.
Goodfield cautions investors against high-yield municipal credits where she expects an increase in defaults, as has been the case so far in 2020, as a result of weak security provisions that were common in many deals in recent years.
“We expect to see more defaults stemming from this economic downturn than we witnessed with the Great Financial Crisis” of 2008-2009, Goodfield said, noting that intensive credit research and constant surveillance are more important than ever for supply and yield hungry investors.
“Despite the strong technicals driving the market right now, it’s not a time for credit complacency,” she said.
Besides increased default risk, there is a chance of continued volatility ahead in the high-yield sector, Goodfield noted.
“Returns in the high-yield segment of the market have varied widely year to date by sector and security, and that is likely to continue,” she added.
Ben Barber, director of municipal bonds at Franklin Templeton Fixed Income, said he believes investors are facing a challenging credit environment as 2020 continues.
“Despite high-grade muni credits trading at their highs, the market continues the theme of price discovery,” he said.
While he said primary market deals overall continue to have very strong reception, secondary market trading is difficult, which is leading to tighter spreads.
“There are still several sectors and many individual securities that are trading at prices far wider than pre-COVID, including some of largest names/CUSIPs in the market,” Barber said.
“As trading focuses on those credits, in general, they’ve continued the tightening trend,” he said.
Analysts are counting on Congress-approved federal stimulus to state and local governments for COVID-19 assistance, which in turn will help overall credit quality.
“We think more support for state and local governments will come, but it may not happen until the fall,” Goodfield said.
“We are very focused on what we believe to be the shorter-term versus longer-term impacts of the COVID shutdown,” Barber agreed, adding that much of the outcome relies on the federal response.
“We’ve been encouraged by many of the proactive steps taken across several sectors within munis,” Barber said.
Elsewhere, market technicals and economic factors are both impacting current investor appetite, and will continue to do so through year end, the managers said.
“Anecdotally, it feels as if there is a lot of cash looking for bonds, muni fund and SMA flows continue to be positive, dealer inventory feels light, and bank selling seems very light,” as tax-exempt supply for the first quarter has dropped to decade lows, Barber said.
Goodfield said new issues – both taxable and tax-exempt — are consistently many times oversubscribed, with orders from a large number of accounts dominating the deals.
Taxable municipals are especially appealing, she noted.
“Institutional investors from the U.S. and elsewhere are actively buying taxable municipals, and they should be, as taxable munis are attractive compared to U.S. investment-grade credit,” she said.
Overall, Barber believes the technical environment for the fourth quarter will be positive for municipals.
“Taxable issuance will likely continue to be a large portion of overall muni supply, and with many of those deals advance refinancing tax-exempt munis, that will continue to decrease tax-exempt supply, which is positive for the technical balance in our market,” Barber explained.
Additionally, with municipal to Treasury ratios above 100% throughout the yield curve, Barber believes tax-exempt securities are positioned to do well versus other fixed income classes.
Brigati, meanwhile, said some underperforming or riskier credits could be expected to work against investors’ long-term goals of principal preservation if and when interest rates rise.
However, he said there is no evidence of that in the near forecast.
“There does not appear to be an imminent threat of higher rates at the moment, but tweaking portfolio holdings when the market is on solid footing and liquidity is available should help in the long run,” he said.