In munis, as elsewhere, signs of improved market functioning
Thanks to unprecedented intervention by the Federal Reserve and Congress' passage of the largest fiscal relief package in history, it seems much of the extreme stress in the functioning of fixed-income markets is behind us. Municipal bonds provide one powerful example of the challenges and then the improvement in market conditions and performance in March. Amid record-setting redemptions from mutual funds and impaired market making by stressed securities dealers, muni yields exploded across the curve in mid-March to historically unheard of levels relative to Treasuries—the ratio of AAA municipal yields relative to comparable maturity Treasuries at one point exceeded 800% at the 2-year spot of the yield curve and exceeded 350% at the 10-year spot! These relative values have narrowed sharply, helping munis mount a record short-term rally, with the S&P Municipal Bond Index returning 8% for the week ended March 27.
The sharp rebound was driven by three factors:
- The Fed’s unleashing of a wide array of support programs across fixed-income sectors, including the muni money markets, helped sharply improve previously stressed market-making;
- Passage of the $2 trillion Coronavirus Aid, Relief and Economic Security Act (CARES Act), which included hundreds of billions in federal funds for hard-hit state & local governments, hospitals and airports and also enabled the Fed to set up programs to support credit markets for states and municipalities;
- The simple fact that high-rated munis were so outrageously cheap from a historical perspective attracted buying from banks, insurance companies and retail investors.
Now, we appear to be transitioning from extraordinary price volatility and relative values to some degree of normalization in market functioning. Munis are still very cheap, but not quite as shocking—the 2-year ratio of AAA muni to Treasury yields is 480% and the 10-year ratio is 197%. We expect some additional decline in ratios, countered partly by an expected increase in muni bond issuance due to pent-up offerings and a likely increase in some short-term financings related to efforts to address crisis-related costs. Nearly every state and all local government faces some form of a balanced-budget requirement. This makes the federal aid that addresses the elevated costs and revenue loss from the crisis essential, and big holes remain unfilled.
The ramifications of the extraordinary partial shutdown of much of the economy are now the key focus of all markets, including munis. Hospitals, airports, and state & local governments all stand to benefit under relief provisions in the CARES Act, but costs and revenues remain highly uncertain and challenging. Meanwhile, essential service providers such as water & sewer authorities and municipally owned power providers stand out as high quality muni bond issuers with lesser challenges related to the Covid-19 crisis. Credit rating downgrades have begun in various muni sectors and will become more common, as will challenging news reports about strained borrowers. That said, as we have seen in prior recessions, high-quality munis (AA and up) remain likely to experience very low rates of credits distress and can be purchased at still very cheap levels.