3Q20 Municipal bond outlook: Remembering returns of principal
The municipal market has rallied significantly since the coronavirus-induced market sell-off that began late in the first quarter and continued through the early second quarter of this year.
In response to the volatile market reaction to the pandemic, Congress and the U.S. Federal Reserve have taken drastic measures, in the form of new legislation and interest-rate cuts, respectively, to support municipalities and municipal bond issuers. These measures have done a good job of stemming market volatility and contributing to the sharp rebound in both the investment-grade as well as high-yield space. As a result of this support, investor sentiment has shifted over the second quarter and municipal bond funds have experienced positive flows every week since the start of May. In addition, the Fed is considering expanding the Main Street Lending Facility to not-for-profit issuers, which could further bolster municipal bonds on a go-forward basis.
This being said, we still see two opposing themes at work in the municipal market that should play out over the next quarter that present a good deal of risk for the space. The first theme is the continuation of the strong technicals that the markets have experienced over the past month. It is our expectation that the municipal market will receive further market support from the Fed on an as-needed basis. The second and more worrisome theme is the fact that municipal fundamentals have deteriorated as a result of the economic shutdown. This could be further hindered by a multitude of unknowns. For these reasons, we believe that cautious positioning both in terms of duration and credit risk is most prudent ahead of the second half of the year.
Currently, benchmark municipal yields are down anywhere from 50-75 bps across the curve since the start of the year. They are either at or near the all-time lows reached in early March. This wouldn’t be as troubling if we were in the middle of an economic expansion and credit fundamentals were improving, but this just isn’t the case. Municipal fundamentals have deteriorated with steep declines in sales tax and income tax revenues, and the economic recovery and reopening is ongoing. In addition, some parts of the country are starting to experience upticks in Covid-19 cases as they attempt to reopen their economies, which could further pressure municipal revenues.
Past the pandemic: continued volatility and election season
Our expectations are for a slight uptick in municipal defaults over the next quarters in select sectors, as well as further downgrades, but we don’t expect a wave of defaults. As we saw in previous economic slowdowns, in times of stress, municipalities have several different levers to pull to both increase revenues and cut or push off expenses. In addition, we do still expect some level of further congressional aid to municipalities in need toward the end of the third quarter. For these reasons, we maintain our quality biases on credits outside of five years in maturity while focusing on lower-grade credits with shorter maturities, high liquidity levels and stronger operating profiles. We expect this to bolster tax-exempt-income generation of our strategies, while mitigating some of the fundamental risks and expected future volatility.
Despite the reversal in market technicals recently, and a continuation of strong demand that we expect to start the third quarter, we do expect further market volatility for the remainder of this year. One of our key themes for 2020 remains considering structural changes to the municipal marketplace that are driving increased volatility. The market sell-off in March spoke to this theme. Furthermore, we’re headed into an election cycle along with economic restarts, both of which will likely be stressed by the pandemic. In light of these factors, we expect fund flows to be anything but stable. Prior to the March market sell-off, the last time the municipal market experienced sustained volatility was following the 2016 election cycle, so why should this year be any different?
If we said to start the year that 2019 was the year for total return and 2020 was the year for coupon clipping, well that couldn’t be more true to start the second half of the year. As the saying goes, municipal investors should be focused less on return on principal and more on return of principal.
Municipal securities can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).