Coronavirus ravages munis, but asset class still attractive
Financial markets went on a wild ride during March. Thanks to the global pandemic, even municipal bonds could not escape the carnage. The past few weeks have been unparalleled.
How terrible was it? Redemptions from municipal bond mutual funds already exceeded four out of the last six full outflow cycles since 2008, and it happened very quickly—in about a month’s time. Two larger outflow cycles, 2010 and 2013, lasted six and 10 months, respectively.
Liquidity premiums skyrocketed as mutual funds raced to meet large redemptions. Indiscriminate selling took root in all sectors of the muni market. As can be expected, lower quality bonds severely underperformed high quality.
A complete disconnect between liquidity providers and seekers exposed the market’s inefficiencies: an asset class dominated by a limited investor base—retail investors—has grown increasingly concentrated. Mutual fund and retail separately managed account subscriptions grew tremendously—over $120 billion for the 14 months entering March 2020. These trends masked less participation from institutions.
Then an estimated $41.7 billion of net mutual fund outflows occurred through the first four weeks of March and the lack of institutional participation became clear.
Over the past decade, broker-dealers have stepped away as large liquidity providers to the market. The 2017 Tax Cut and Jobs Acts diminished interest from insurance companies, banks and other institutions that typically increase demand during liquidity-driven events. As a result, the institutional buyer base could not react quickly enough to take advantage of the opportunity.
Credit challenges associated with COVID-19 could create a critical situation for some municipal credits. Investors should be ready for headlines announcing that municipal debt issuers require support from federal or state governments, possibly both.
But the demand destruction rolling through the U.S. economy may prove temporary rather than permanent.
Buy now or wait to time the market bottom? It feels terrible to invest today, at a time when municipal bond prices appear to only want to nosedive. Yet history shows that an indiscriminately plundered market usually provides rare opportunities for investors with longer investment horizons.
We are using market volatility to improve yields in our portfolios, maintaining positions that can weather the storm while adding mid- to lower-investment-grade bonds and liquid credits at severely discounted prices.
The most stressed sectors—transportation, industrial revenue (IDR) and corporate-backed issues—were dumped amid the first wave of redemptions. We like gas prepays, which are muni bonds backed by large financial firms with strong, stress-tested balance sheets. These credits have the fundamental strength to withstand economic uncertainty and diversify traditional public finance sectors at the center of rolling economic lockdowns.
Other beaten-down sectors also offer potential rewards for taking on incremental risk in a low-liquidity environment. Bonds supporting transportation, mass transit, airports and toll roads are adversely impacted by lower usage fees (ridership). Projects that need to meet ridership targets to fund debt service are particularly concerning. Many credits in the transportation sector have very strong balance sheets, however, and may snap back quickly when the worst of the pandemic passes.
Yet we are cautious about some of the recently issued high-yield transactions, specifically those supported by capitalized interest and aggressive revenue targets that might not materialize under even a temporary demand destruction scenario.
Major natural disasters may be the only good proxies for what can happen when entire regions confront complete, short-lived economic shutdowns, such as the hurricanes that ravaged New Orleans (Katrina) and Houston (Harvey). Municipal credits were severely challenged but ultimately succeeded in overcoming them.
How good a bet are municipal bonds, historically? During the last 14 S&P drawdowns of 10% or greater, municipals outperformed equities on average by +23% and investment-grade corporates by +1.4%, after taxes.
With all the action roiling the markets they may no longer be viewed as boring, but municipal bonds still offer solid opportunities for long-term investors to lock in favorable levels of tax-exempt income at attractive prices.