fixed income update HERO

Municipal Bonds: Where We’ve Been and Where We May Be Headed

04/01/2020

by Jonathan Rocafort, CFA, Managing Director, SMA Portfolio Management

Following a record sell-off and snapback, municipal bond investors may be wondering whether a historic buying opportunity has come and gone. Though the asset class has staged a dramatic turnaround following a surge in yields, we believe bargains still exist. Yields remain well above the recent lows. Relative value is compelling. Additionally, unprecedented actions by the Fed and the $2 trillion coronavirus bill should support liquidity and address near-term fiscal challenges. Volatility may persist as muni mutual fund outflows continue and credit concerns linger, but we believe demand for municipals should remain strong as investors continue to find value in attractive tax-adjusted yields and downside protection amid potential future volatility. Let’s review what has transpired over the past three weeks, where that leaves us today, and the opportunities we see in the wake of this historic move.


Let’s review what has transpired over the past three weeks, where that leaves us today, and the opportunities we see in the wake of this historic move.


Before the sell-off started

Muni yields fell to all-time lows on March 9. This contributed to the speed and magnitude of the sell-off as retail demand faded at the start of the month.


Market update table


In 2019 the municipal bond market posted its highest annual return since 2014, with the ICE BofAML US Municipal Index up 7.74%. The cap on the state and local tax deduction for higher-income earners—implemented as part of the Tax Cuts and Jobs Act of 2017—created a greater appreciation for munis as a tax-avoidance tool. The result was 52 consecutive weeks of muni mutual fund inflows totaling $93 billion and eclipsing the annual record set in 2009. This market strength continued into 2020, with an additional $23 billion flowing into muni mutual funds through the end of February. Strong demand—combined with falling Treasury yields—put the ICE BofAML US Municipal Index up 3.17%, year to date (YTD), through February 28. This combination also sent the 10-year AAA muni yield under 1% for the first time in history. On March 9 a 10-year national AAA muni had a yield of only 0.81%—an all-time low.


Why did municipals sell off, and how significant was the move?

As concerns over the coronavirus and its economic impact began to grow, muni mutual funds—particularly high-yield funds—began to see large redemptions over the second week of March. This ended a streak of 60 consecutive weeks of inflows. With retail investors balking at yields inside 1%, the first wave of forced selling was met with little support. Dealers were forced to back up their bids significantly as their balance sheets swelled and Treasury volatility made hedging a challenge.


Falling prices only made matters worse. Redemptions picked up steam. According to Refinitiv Lipper, investors pulled $12.2 billion out of muni funds during the week of March 16, almost triple the previous record. With dealers full, the rout resulted in a liquidity crunch reminiscent of 2008. By March 20 the yield on a 10-year AAA muni increased to 207 basis points (bps), to 2.88%, since the lows on March 6. In addition, the ratio of a 10-year AAA muni to a 10-year US Treasury had set an all-time record, surpassing 300%. The ICE BofAML US Municipal Index had declined 11.66% over the two-week period from March 6 to March 20 as its yield spiked to a six-year high.


Market update table


How the coronavirus liquidity crunch compares with other historic sell-offs

The coronavirus liquidity crunch proved to be a more dramatic move compared with other historic sell-offs, including the 2008 financial crisis, the 20102011 sell-off following Meredith Whitney’s call for a surge in muni defaults, the 2013 taper tantrum, and the period following the 2016 presidential election. The magnitude of the yield move, the resulting performance drawdown, and the extent to which munis cheapened relative to Treasuries exceeded all those historic moves. Like the current sell-off, the weaker markets rattled nerves. They were also often viewed by muni market participants as an attractive entry point. As highlighted in our March 23 blog post, we believe a similarly attractive entry point has emerged.


Market update table


Why did the market turn around so quickly?


Following the historic rout the week of March 16, the week of March 23 began with high-quality muni yields exceeding those of similar corporates for the first time in this cycle. Additionally, the muni-to-Treasury ratio was in excess of 300%. The stage was set for savvy investors to emerge and offer support for something too tempting to ignore: high-quality bonds at fire-sale prices.


On March 23 the Fed announced unprecedented measures to shore up muni liquidity, including one to expand the existing Money Market Mutual Fund Liquidity Facility to include a wider range of securities, such as municipal variable-rate demand notes. In addition, the $2 trillion coronavirus bill was coming into focus, with at least $350 billion in aid, grants, loans, and funding for municipal sectors and entities. As a result of the bill, the market began to find support at yields of 3%–4% for high-quality AA names from direct SMA buyers and crossover buyers such as banks and insurance companies. An enormous amount of capital materialized in a short period of time, sending high-quality muni yields down 165 bps over the week and the ICE BofAML US Municipal Index up 8.67%. This was a staggering comeback from the liquidity-induced rout that plagued the market during the previous two weeks.


Market update table


Let’s look at the yield changes over the sell-off, the historic turnaround, YTD, and where current yields are compared with the historic lows on March 9.


Market update table


Where are we today?


While the rebound has removed the extremely oversold condition from the market, we think the current environment still offers favorable relative value when compared to Treasuries and corporates. Investors still have the opportunity to invest at attractive real rates of return, especially considering the disinflationary pressure of the pandemic. We also remain approximately 60 bps higher in yield compared to the lows on March 20.


Market update table


For those investors thinking they missed the opportunity, we remind them volatility is likely to continue. A number of factors may lead to higher yields and continued volatility in the near-term, including:

  • Continued muni mutual fund outflows
  • An uptick in new issue supply
  • The potential of less support from crossover buyers such as banks
  • Perceived heightened credit risk
  • Direct buyers and SMAs balking at lower yields given heightened credit risk

We see value in the trading opportunities created by market volatility. For those looking to add alpha, we recommend our intermediate and long active strategies. For investors seeking the performance and definition offered by a ladder, investors can capture 86% of the available yield on the curve in the 14-year maturity, so we believe that a one-to-14-year ladder represents good value. Wary investors can spare themselves some volatility with a one-to-eight-year or one-to-10-year ladder at the cost of some yield.


Following a record sell-off and snapback, a historic buying opportunity has not necessarily come and gone. Yields remain well above the recent lows and relative value is attractive. Volatility is likely to continue and should provide investors with attractive entry points and relative value trading opportunities.




For Municipal Bonds, Falling Prices and Rising Yields

March 23, 2020

by Christopher Harshman, CFA, Director, Portfolio Management

Not since 2008 have financial markets witnessed their current level of volatility, which is coursing through nearly every asset class. In municipal bonds, after a strong start to the year, early March brought dislocation from Treasuries amid a market-wide flight to safety as global health concerns continued to escalate. 


High-yield muni mutual funds in particular have seen large redemptions, prompting aggressive selling into light liquidity. This is reminiscent of 2008, when even high-quality assets were sold as investors wanted to move to cash—and today again the result has been rapidly falling prices and rising yields as the market seeks to find its footing.


While there may indeed be longer-term credit considerations, the current liquidity crunch is technical in nature and is pressuring valuations. What will end this cycle will be a combination of reduced selling pressure and an increase in retail investor demand, likely to be spurred by high-quality assets at fire-sale prices and yields. (For example, the end of last week witnessed short high-grade California yields above 3% and intermediate high-grade New York yields above 4%, tax free.)


Yields on high-quality municipal bonds, relative to yields on US Treasury bonds, are now at unprecedented levels. The chart below shows how yields have risen since the recent low of March 6 and how the ratio of benchmark AAA muni yields to US Treasury yields has risen as well.


Market update table


Source: Bloomberg, Thomson Reuters, 3/20/2020. For illustrative purposes only. Not a recommendation to buy or sell any security.


Despite the Fed taking action to stabilize money market funds last week, tax-free variable rate demand notes benchmarked to the SIFMA rate—akin to LIBOR-linked securities in the corporate market—have seen yields rise rapidly to historic levels. Again, this is a reflection of a lack of demand and strained liquidity in the muni market. For longer-dated AAA fixed-rate municipal bonds, the graph below isolates the 10-year yield ratio over the last 30 years (10-year AAA municipal bond yield divided by the 10-year US Treasury yield), putting the current market environment into context.


Market Update Graph


Sources: Bloomberg, Thomson Reuters, 3/20/2020.


We believe the current volatility may persist. However, history shows us that extreme distortions in municipal valuations over the short term may give long-term investors a compelling entry point.


There are two primary things for investors to consider at the moment. The first is the market dislocation resulting from fear and uncertainty, leading to reduced market liquidity and high volatility. The second is the fundamental credit concern about the severity and duration of this health crisis and the ultimate long-term effects on the economy.


We see opportunity in the volatility. We believe the economy will recover. In municipals, many individual sectors will have unique considerations, but overall we believe high-quality issuers will weather the storm. (We’ll discuss the credit-quality effects of the crisis in a forthcoming blog post later this week.) And we’re encouraged by the fact that, once the dust settles, an unprecedented amount of coordinated fiscal stimulus stands ready to restart the global economic engine. The short term may indeed bring more volatility—but investors can use the current environment to set the foundation for future positive investment outcomes with municipal bonds.

 



Can Strategy Stability Outlast Market Volatility?

March 20, 2020

by Bernie Scozzafava, CFA, Director, and Tom Luster, CFA, Managing Director, Taxable SMA Strategies

The sell-off in the equity market sparked by the coronavirus has spilled over to the intermediate investment-grade (IG) corporate bond market, resulting in nine straight days of negative returns. Such a stretch has happened before, but this time the cumulative decline was a record -9.8% for IG bonds, which are the primary building blocks for corporate ladders. While the 2008 credit crisis produced larger price declines, they occurred over a longer period of time. When markets experience such precipitous price action, it’s natural for investors to be concerned that there will be further losses, so they look to raise cash.


Despite this fear, there’s been a historical trend of markets overshooting on the downside, which can prove to be rewarding for investors who continue to hold through such volatile periods. In other words, the higher yields available today on IG bonds could prove an attractive time to invest.


Market decline driven by liquidity concerns


When it comes to selling during times of extreme volatility, it’s only a good practice if you have a near-term cash need, your portfolio requires rebalancing, or there are better opportunities in other markets. For those looking to sell, liquidity is available. The drawback: Trading costs can now exceed 3% when they’ve normally been hovering around 0.10%. This increased cost isn’t limited to corporates—the US Treasury market is struggling to find liquidity in this time of unprecedented market action.


Efforts to control the spread of the coronavirus in the US were implemented rapidly and are having an immediate negative effect on the economy. Individual investors have been focused on making sure they have sufficient liquidity to carry them through this global pandemic. Large corporations have reacted in much the same way, with many companies borrowing on their credit lines to ensure they have sufficient liquidity to maintain operations or to weather the storm. While this provides short-term relief, it puts additional pressure on the financial system, which has been compounded by the collapse of oil prices.


Record redemptions


Investors were all set to have a banner year in 2020, with fund inflows reaching record highs during January and February. The coronavirus outbreak has since caused fund flows to reverse direction, leading to record redemption—and at an alarming rate. During the past week, the broad category of IG funds experienced an outflow of over $40 billion, which was four times the last largest redemption amount set just a week prior. Both mutual funds and ETFs witnessed significant withdrawals, causing the latter to trade at discounts to net asset value not seen since the 2008 credit crisis. This trend may continue to materialize throughout the market until the impact of COVID-19 fades.


Record yields


Amid the head-spinning volatility of the past few weeks, IG bonds set a record-low yield of 1.8% on March 5. Since then, the yield has more than doubled—rising to 4.3%—exceeding the prior 10-year high of 4.1% and well above its average of 2.9% over that period. Yields are now the highest we’ve seen since we started building corporate ladder portfolios in 2012.


Upside opportunity


Markets don’t like to operate with uncertainty, but under the current circumstances it’s unclear for how long consumer behavior will be affected by efforts to control the spread of the coronavirus


If policymakers have learned anything from the 2008 crisis, it’s that unprecedented times call for decisive and forceful responses to restore investor confidence and to stabilize financial markets. We’re seeing this approach being implemented now with the Fed cutting rates to nearly zero and implementing quantitative easing.


The bottom line


Making significant changes to portfolio positions in the middle of this market turmoil could prove to be expensive and leave investors on the sideline when prices recover. We suggest being patient. Don’t let volatility dictate financial decisions. This is a time to assess financial situations and goals and to make any adjustment to portfolios with extreme care.


At the same time, we believe current yields represent an attractive entry point. We see markets normalizing over time as historic measures are being taken to combat the threat of COVID-19 across the globe.




Are Municipal Bonds Poised for a Comeback?

March 18, 2020

by Jim Evans, CFA, Chief Investment Officer, Fixed Income

After setting a record low of 0.78% at the beginning of March, the yield on a 10-year AAA municipal bond has increased to 1.86%, a one-year high and in line with a five-year average. The size and speed of the move is similar in nature to sell-offs witnessed in 2008, 2010–2011 (the “Meredith Whitney” period), and the 2013 Taper Tantrum. Many muni participants look on those weaker markets as having been an attractive entry point. A similar opportunity may be emerging.


What's happening with municipal bond yields?


Throughout January and February, municipal yields were dragged down in sympathy with Treasury yields. However, municipals are a retail-dominated product, and individual investors began to balk as the yields on 10-year investment-grade municipals dived under 1%. While evaluation prices went up, liquidity thinned and the market ceased to facilitate trade. Muni mutual fund and ETF outflows began the second week of March and continue this week. Combined with retail selling driven by both profit taking and rebalancing, the market is seeing more sellers than buyers. As a result, dealers and market participants have backed up their bids and yields have spiked dramatically.


The good news about muni yields


Muni yields reflect real rates of return that we find compelling. With absolute yields back to long-term averages, munis can resume their place as an attractive source of after-tax income and as a diversifier to equity and equity-like risk found in other areas of fixed income. This may be particularly valuable in this environment. In addition, market moves over the past two weeks have cheapened munis’ relative valuations versus taxable vehicles to a point rarely witnessed in history. Muni investors are typically rewarded with outperformance when we get to these types of valuations.

While this turmoil persists, we see these factors as supporting investment-grade municipals and corporates:

  • We expect Treasury yields to be low and close to zero for quite some time.
  • We view investment-grade municipals and corporate yields as attractively valued.
  • We anticipate further unprecedented fiscal and monetary support from the US government and the Fed to support corporations and municipalities.

Daily updates


While the market is undergoing exceptional volatility, we’ll post the change in yields from the previous Friday and the daily valuation of municipals and corporates. Liquidity will likely change significantly from day to day.


On Tuesday both municipal and corporate bonds continued to exhibit wide bid-offer spreads. For those looking to rebalance or liquidate, particularly with smaller lots, liquidity is available but may result in a -3% to -10% discount from the pricing service evaluation. We’re seeing the same liquidity this morning.


Daily yield update





 

 

Municipal and Corporate Bonds May Help to Weather the Storm

March 17, 2020

by Jim Evans, CFA, Chief Investment Officer, Fixed Income

While the market is undergoing exceptional volatility, we’ll post the change in yields from the previous Friday and the daily valuation of municipals and corporates.

On Monday and into this morning, both municipal and corporate bonds are exhibiting wide bid-offer spreads. For those looking to rebalance or liquidate, particularly with smaller lots, liquidity is available but may result in a -2% to -7% discount from the pricing service evaluation. This isn’t limited to munis and corporates, even US Treasuries are suffering from a lack of liquidity. Generic 10-year Treasuries are quoted with a $0.30 bid-ask on electronic trading platforms; the bid-ask is normally about one one-hundredth of that.

This morning the US Federal Reserve reinstated their commercial paper funding facility that was used during the financial crisis. This is an impactful move and should provide significant liquidity for any corporation in a cash crunch.

Daily yield update





Fixed Income Market Update

March 16, 2020

by Jim Evans, CFA, Chief Investment Officer, Fixed Income

COVID-19 has caused substantial upheaval in the financial markets, and municipal and corporate bonds haven’t been immune. Last week all fixed income markets outside of Treasuries had bouts of illiquidity and significant underperformance versus Treasuries. Bonds showed wide bid-offer spreads as of Monday morning; we expect wider spreads and persistent volatility to come.


Investment-grade markets stabilized on Thursday after the US Federal Reserve announced it would provide $1.5 trillion in short-term loans to banks in return for Treasuries. Over the weekend, before world markets opened on Sunday, the Fed cut interest rates by a further 100 basis points (bps), bringing the target federal funds rate to the zero-to-25-bps range for the first time since 2015.


For the week, two-, five-, 10-, and 30-year municipal yields rose 62 bps, 76 bps, 80 bps, and 83 bps, respectively. The table below shows the spot yields as of March 13 on A-rated municipals, valuations versus Treasuries, and valuations versus A-rated corporates. It also shows the average valuations from 2019. Municipals appear attractive to us across the board.



Corporate bonds likewise saw a significant sell-off last week, with yields in the two-, five-, 10-, and 30-year rising 53 bps, 63 bps, 64 bps, and 73 bps, respectively. Corporate bonds relative to Treasuries also seem to be very attractive.



While this turmoil persists, we see these factors as supporting investment-grade municipals and corporates:

  • We expect Treasury yields to be low and close to zero for quite some time.
  • We view investment-grade municipals and corporate yields as attractively valued.
  • We anticipate further unprecedented fiscal and monetary support from the US government and the Fed to support municipalities and corporations.

We believe investment-grade municipal and corporate bonds may provide more attractive income and return opportunities relative to Treasuries of comparable maturity. In our view, professional credit oversight will be very important going forward to assist with avoiding credit deterioration.


Potential Parametric solution

Constructing your own bond ladders—and factoring in interest rate risk, credit risk, and other crucial aspects of fixed income investing—can consume an advisor’s time. Parametric’s professionally managed municipal and corporate ladders make it easy, helping you offer your clients portfolios tailored to their needs, all in a way that’s simple and scalable for you.



The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.


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