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AAM Viewpoints – Dislocation in the Municipal Bond Markets


The past 30 days have seen an unprecedented dislocation in the fixed income markets, especially the municipal bond market. Historically, tax-exempt municipal bond yields have been lower than taxable yields which just makes sense as the investor in tax-exempt municipal bonds is exempt from federal taxes and, in some cases, state income taxes. Over the years, a very general rule of thumb was when tax-exempt yields are 70% of Treasuries, municipal bonds historically are a sell, and when municipal bond yields are 90% of Treasury yields, municipal bonds can be an attractive buy. We believe this rule of thumb makes sense when one applies the federal income tax rates to the taxable yield generated by a U.S. Treasury bond.

For example, applying the above guidelines and using the industry standard Municipal Market Data (MMD) AAA scale (which provides the offer-side of AAA-rated state general obligation bonds) as the municipal bond benchmark: if the U.S. Treasury 10-year bond is at a 2.00% yield, the MMD AAA 10-year bond yield should be somewhere between 70% of the U.S. Treasury yield (or 1.40%) and 90% of the Treasury yield (or 1.80%).

The dislocations that occurred in the municipal bond markets in March are illustrated in the charts below depicting the comparison in yields between the U.S. Treasury market and municipal markets in the 2-year, 10-year and 30-year maturities.

Please note in each example, the extreme left of the chart where the municipal bond yields are lower than the Treasury bond yields which is typical in a more normalized market. Around March 5th, the yields start to invert until they reached an extreme around March 24th.

2yr UST and MMD

Source: AAM

10yr UST and MMD

30yr UST and MMD

Source: AAM

So, why such a dislocation? It is generally thought this occurred because of the illiquidity in the bond markets caused by selling pressure from investors liquidating their municipal bond funds and exchange-traded funds (ETFs). The chart below shows that following 60 straight weeks of inflows dating back to December 2018 there were two weeks of redemptions totaling over $40 billion.

ICI long-term mutual fund and ETF flows

Source: AAM

The market could not absorb this supply especially given the lower balance sheets allowed at banks from the Dodd-Frank legislation.

There are numerous reasons given for the mass liquidations, but a couple of the more obvious are investors rebalancing their portfolios to move from bonds into the equity markets and/or a fear that the nationwide lockdown has put many municipal credits in danger because of the reduction in revenues and taxes caused by the diminished interaction between consumers and businesses, as well as the significant increase in unemployment.

Is there still opportunity for investors in the municipal markets? Our answer is yes. In the three charts comparing the U.S. Treasuries to the MMD scales, in general, the municipal bond yields that make up the MMD AAA scale are still over 100% of Treasuries as shown in the far-right side of the graphs. However, investors must be extremely careful as many believe that there will be credit issues with various municipal issuers as a result of the economic environment the United States is currently experiencing and will continue to experience in the foreseeable future.

There are two sides to every story and two sides to every market; as always consult your financial advisor before investing.

 

CRN: 2020-0406-8183R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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