Seeing opportunity amid the chaos

As a recession becomes highly likely amid sharp social-distancing steps to restrain propagation of the coronavirus, municipal credits are—or will soon be—facing financial pressures: sales & income tax revenues will fall for state governments, bonds supported by dedicated sales taxes will face declining coverage, revenues at airports already are declining and not-for-profit hospitals will be struggling with rising demand but uncertain shifts in costs and revenues for treating Covid-19 cases. Governments with high fixed costs related to pensions and rising Medicaid also will be key risks to watch. Non-governmental muni bonds that are obligations of 501(c)(3)s providing care to senior citizens or backed by for-profit companies in the industrial or transportation sectors are of particular focus in these difficult times. In fact, investors pulling money from high-yield muni funds and ETFs have been especially wary of such non-governmental credits, accounting for a large portion of fund outflows in these difficult markets. 

However, be skeptical of market commentators who suggest that the recent underperformance of muni bonds relative to U.S. Treasuries is due to fear of widespread defaults. The impaired functioning of market making—banks and securities dealers committing capital to make markets in all non-U.S. Treasury fixed income—is the primary reason muni bonds have underperformed relative to Treasuries this month. The credit implications of a sharp, but perhaps short-lived, recession are important risks to consider, sure. But this is secondary to the simple strained functioning of over-the-counter markets in explaining what the world is seeing: ratios of AAA muni yields to comparable maturity Treasuries running from 170% for 30-year bonds to more than 300% at the shorter of the yield curve, a gap that’s almost certain to narrow as market dislocations eventually subside amid emerging Federal Reserve actions to support better functioning capital markets.

In fact, high-quality muni bonds should be viewed as a potential buy in this environment. Better market functioning eventually should lead to high-quality muni yields declining from current levels relative to U.S. Treasury yields, producing relative outperformance in price compared to U.S. Treasuries, all while producing tax-exempt income that is sharply higher than income from fully taxable U.S. Treasury debt.  Muni credit quality has been improving recently and, before this virus event, valuations were rich. Now valuations are cheap and our job is to identify risk and reward among this cheaper universe. When the dust settles from this volatile period, muni default rates should remain well below those of corporate bonds. At some point in the near future, munis at current cheap valuations likely will be regarded as an opportunity missed for those who don’t start buying at current levels.