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AAM Viewpoints – Patient and Prudent Investors Could See Value in Municipal Market Dislocation


Municipal (muni) markets typically turn at the speed of a tanker ship, move at the speed of molasses in January and rarely see daily price swings of more than a few basis points. These characteristics are the hallmark of an asset class built for capital preservation and income. Investors and managers alike rarely experience the type of volatility, both the magnitude and the speed, that municipal markets have exhibited over the last month. The only recent frame of reference is the 2008 credit crisis. The current environment, in addition to 2008, likely represent the only two dislocations of this magnitude in the last 15 to 20 years with both happening in what, for the municipal market, is a blink of the eye. During the peak-to-trough height of the credit crisis for the municipal markets (9/9/2008 to 10/15/2008) the Bloomberg Barclays Municipal Bond Index was off just over -11% (11.12%). Assuming the worst is behind us today, during the peak-to-trough height of the more recent coronavirus related sell off (3/9/2020 to 3/23/2020) the same index was down just shy of the same -11% (10.94%).

For those who experienced municipal markets in 2008, it felt oddly reminiscent as does the enthusiasm for opportunity as orderly, well-functioning markets return. Patient and prudent investors in municipal securities through the 2008-2009 period were amply rewarded. After plunging over 11% from 9/9/2008 to 10/15/2008 the Bloomberg Barclays Municipal Index re-tuned, in fits and starts, just shy of 21% by the close of the following year (10/15/2008 to 12/13/2009). Past performance is certainly not indicative of future results and the impetuses behind the dislocations vary with the current economic impact still far from certain. With that being said, it is not unreasonable to think the most recent capitulation could spell opportunity over time as uncertainty wanes.

To be fair, the 2008 recession brought with it a heightened strain on credit quality as it impacted on state and local finances, exposed many state and local government pension systems as woefully underfunded and brought a heightened awareness of credit and liquidity risk that permeated the market for years to follow. The current situation could be the same. One must acknowledge that shuttering the U.S. economy for weeks, if not months, will undoubtedly impact state and local revenues and tax receipts. It will likely strain mass transit and airports. Finally, it will almost certainly impact healthcare and state and local municipalities with a heavy reliance on tourism. The potential situation has been acknowledged by the federal government in the last few days with unprecedented actions that include direct fiscal assistance and low-cost lending facilities for local and state governments in addition to the Federal Reserve investing directly in both primary and secondary issuance. Still, for investors patient enough to weather the storm and prudent enough to understand the likely new normal with regard to credit and liquidity risk, there is likely quite a bit of opportunity given recent events.

Simple prudence and patience! But what does that mean for the average municipal investor? First, we would remain patient as liquidity returns to bond markets. Credit concerns have likely played a role, as mentioned, but orderly well-functioning markets would have likely priced in credit risk in a much more efficient manner if not for the subsequent liquidity crunch which played an outsized role in market volatility. Not only were valuations based on benchmark yields, taxable equivalent yields and muni-to-Treasury ratios all sitting near post-2008 highs likely a market ready for a breather, the asset class had seen a staggering 60+ week of inflows.

All good things must come to and end and the reversal was swift and record setting with an all-time market high 19.3 billion outflow for the week ending 4/1/2020 on the heels of a 19 billion outflow the week before. A sharp drop in price was the inevitable result with little to no bid-side support from dealers, investment banks and other traditional liquidity providers amidst closed-end funds, mutual funds, ETFs (Exchange-Traded Funds) being forced sellers. Buyers at fair value can still be hard to find. Remaining patient as liquidity returns and adding to holdings at current levels is likely the best course of action for most investors, in our opinion. Current valuations look quite attractive but do come at the expense of a less liquid market requiring patience as any recovery likely comes in fits and starts. Individual bonds in lieu of bond funds have the potential to be a good course of action moving forward as it puts the buy/sell/hold decisions in the hands of the investor/manager as opposed to being at the mercy of forced selling and fund redemptions.

We would approach the markets in a prudent manner with an acknowledgement that we may see a new normal regarding municipal credit and liquidity risk, most predominantly in the near term. Sentiment and psychology are likely to weigh heavy and most would agree the municipal markets were likely a bit apathetic and sanguine on credit and liquidity risk pre-coronavirus. The Bloomberg Municipal High Yield Index was at worst down almost -19% (-18.9%) from 3/6/2020 to 3/23/2020 and even amongst higher grade credits of comparable ratings we are seeing the market differentiate amongst sectors on the basis of yield with some larger mass transit and airport systems garnering bids below par based on MSRB data. We would certainly not stretch for yield in the current environment and would make prudent credit decisions. These include adding more impacted sectors such as transportation, healthcare and higher ed in smaller positions sizes, avoiding all together some of the more at-risk credits, opting for larger more liquid holdings and looking at larger allocations to the highest quality GOs (general obligations) and essential service revenue bonds (water, power, electric, sewer). Moving forward we would have heightened credit surveillance in several areas including: credits sensitive to energy, credits directly impacted by coronavirus (higher education, airports, transportation, healthcare, etc.) and credits more broadly impacted by an economic downturn including the impact of recent equity-related pension losses at the state and local level.

The volatility and lack of liquidity over the last month were certainly not unique to municipals. The same dynamics were evident across most fixed income markets. In fact, for all the volatility, municipals held up better than most, with corporates and high yield faring even worse. While much of the volatility can be attributed to a lack of liquidity one must acknowledge the heightened credit risk. While many of these credits had strong balance sheets, free cash flow metrics and liquidity/access to capital that left them likely able to withstand a protracted coronavirus downturn, it was good to see the Federal Reserve and Congress take action to support state and local municipalities. We have taken back a good portion of the losses at their worst, but we believe the asset class is still attractive by just about any metric. We think the asset class while strained should maintain one of the higher credit qualities available in U.S. fixed income market even with potential downgrades. The 10-year muni-to-Treasury ratios sits at almost 300% which is nearly three times the average over the last 20 years. Taxable equivalent yields are comparable to BBB and in some cases lower-rated corporates. Finally, it is a buyers’ market for those who understand liquidity is still a bit weak. We are constructive on the asset class for capital preservation and income moving forward for the patient and prudent investor.

 

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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