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AAM Viewpoints – Municipal Market’s Swift Recovery Overshadows Tailwinds


One thing is for certain, there has been no lack of conversation surrounding the shape of the recovery across both equity and fixed income markets. If only it was as simple as boiling it down to a particular letter of the alphabet, we could all be sitting on the beach drinking our favorite cocktail. The tax-exempt municipal markets are certainly no exception and one could be easily flummoxed trying to assign a shape to the recent recovery. Maybe a V-W combo recovery with a little “swoosh” to boot? Regardless of the shape, the recovery has been a swift return to sanity that has been rewarding those who took advantage. The Bloomberg Barclays Municipal Bond Index posted the best monthly return in the last 11 years in May 2020, up 3.18%. Benchmark yields now sit inside pre-coronavirus levels with the shortest tenors approaching zero (three-month/six-month 15 bps [basis points], one-year 16 bps, two-year 22 bps). While the sharp recovery is certainly welcome, it overshadows building tailwinds in the asset class that could provide further support for increased valuations moving forward.

Bloomberg Barclays Municipal Bond Index

bloomberg barclays municipal bond index

Source: Bloomberg | Past performance is not indicative of future results.

Technical indicators and macro-economic fundamentals both point to the possibility for continued strength in municipals. Supply is likely to remain constrained, relative value measures remain elevated, credit spreads still have room to tighten and the economic backdrop looks to be improving. That said, much of the “value” moving forward reflects the uncertainty surrounding the ultimate impact of the coronavirus-induced recession on city, county, and state finances. While signs point to value in municipals, the added uncertainty likely enhances the need for active management. 

Primary municipal issuance is up through the first two weeks of June and on a year-over-year basis. The 30-day visible supply number on 6/17/2020 of 16.6 billion was almost 15% higher than the 2020 year-to-date average of 14.5 billion. The 2019 30-Day Visible Supply average was 11.9 billion. One might think that the supply woes of the last several years are abating; however, the numbers eclipse a significant curtailment of tax-exempt issuance. Both the recent increase in June supply and the year-over-year increases this year are being driven by increasing taxable issuance. Tax-exempt yields in many areas are still elevated relative to Treasury and corporate yields and many issuers are able to tap the corporate and taxable municipal markets at lower rates than traditional tax-exempt markets. Furthermore, many of these issuers – healthcare systems as an example – are outside the confines of the traditional city, county and state government issuance, which has been slow to recover.While supply is expected to increase, Citigroup estimates principal and interest payments will outstrip new issuance by 19.5 billion in June and 52 billion for the three-month period ending in August. The supply/demand imbalance that has been a permanent fixture of tax-exempt municipal markets over the last several years does not look to be going anywhere and, if anything, could be accelerating which could likely provide support through the balance of the year. Higher valuations as a function of supply are also supported by recent fund flow numbers. Municipal mutual funds and ETFs (Exchange-Traded Funds) brought in a whopping 4.2 billion for the week ending June 10, which marks the sixth straight week of inflows.

In addition to supply constraints most relative value measures remain elevated. This points to the potential for further tightening in municipals relative to other fixed income asset classes such as treasuries and corporates. The 10-year Municipal-to-Treasury (M/T) ratio, a closely followed municipal relative value metric, currently sits at just shy of 117%. Notwithstanding the recent sell-off, this represents the cheapest level versus treasuries in the last five years. The M/T ratio compares benchmark yields in the Municipal-to-Treasury yields and typically hovers just shy of 100% reflecting the additional compensation on municipals that comes via the tax exemption which tends to push the absolute yield on municipals through Treasury yields in most market environments. As the number moves up municipals are looked at a cheap to Treasuries and as the ratio moves down municipals are considered to be rich. To begin the year, pre-coronavirus, the 10-year M/T ratio sat at 73% (1/21/20) one of richest levels in the history of the municipal market.

10-Year Municipal-to-Treasury Ratio

10-Year Municipal-to-Treasury Ratio

Source: Bloomberg | Past performance is not indicative of future results.

Municipals also look attractive on a relative basis versus investment grade corporate bonds. The ratio of the Bloomberg Barclays Municipal Bond Index yield-to-worst relative to the Bloomberg Barclays Investment Grade Corporate Index yield-to-worst sits at 71% which is a two-year high.

Investment Grade Tax-Exempt Municipal/Investment Grade Corporate YTW Ratio

Investment Grade Tax-Exempt Municipal/Investment Grade Corporate YTW Ratio

Source: Bloomberg | Past performance is not indicative of future results.

The current disparity between tax-exempt municipal and corporate yields carries the potential to bring in even more demand in the form of relative value investors. Otherwise known as “crossover” investors, they typically seek out the best returns moving from one asset class to the other as after-tax yields dictate. The current relative value positioning of municipals is all the more attractive when one considers the significant disparity in credit quality between the two asset classes. Roughly 50% of the U.S. investment grade corporate market resides in BBB territory while over 90% of the municipal market resides in A or better credits. AA credits constitute roughly 50% of the broad Bloomberg Barclays Municipal Bond Index.The Federal Reserve has taken unprecedented actions to support both the corporate and municipal markets. These efforts have had dramatic impacts on both markets; however, it seems to be influencing the corporate markets to a larger degree. This leaves municipals as an attractive option relative to corporates, especially those of comparable credit quality.

Macroeconomic fundamentals could also be a tailwind for municipal markets. Recent data such as jobless claims and retail sales have shown broad improvement as the U.S. economy seeks to reopen. Data surprises to the upside have accelerated with numbers well ahead of expectations as reflected in the Citigroup Surprise Index’s recent rise to record levels.Should broad-based improvement in the economic backdrop continue it would likely be a credit positive for state and local governments with increasing tax receipts and improving revenues. The benefit for municipals would likely come in the form of narrower credit spreads and in turn higher prices. Currently, municipal credit spreads sit at some of their wider levels in the last several years providing yet another example of potential tailwind.

While municipals do look attractive moving forward the potential reward does come with risks. Much of the potential upside in municipals, as reflected in elevated relative value measures and wider than average credit spreads, is a function of uncertainty surrounding the impact the economic slowdown will have on municipal revenues and tax receipts. While the reward may be easy to quantify, the risk, in many cases, is not. Understanding the risk-to-reward trade off is essential, and this is particularly relevant against a low interest rate environment. Passive buy-and-hold strategies have no mechanism to mitigate risk over time. We believe the current environment begs for active management and the ability to tactically adjust credit and interest rate risk. Credit ratings tend to be a lagging indicator of actual credit quality and active management bridges the information gap most retail investors face in fixed income markets by allowing for a more leading approach to changing credit dynamics. Municipals are not a one-size-fits-all solution. Advisors should always consider clients’ objectives, but for investors seeking out capital preservation and tax-free income they may want to consider an actively managed approach to municipals as a potential option, where appropriate.

 

CRN: 2020-0604-8341 R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond for the trust units in any way.

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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