INSIGHTS

On October 26, 2020

AAM Viewpoints – Be Ready to Lock-in Yields When the Opportunity Arises

As the election approaches, market participants are being more cautious about their investment decisions. While there are a lot of market-centric reasons for this approach, there are as many non-market related ones as well. Regardless of the reason, however, we continue to advocate for financial professionals and their clients to remain nimble and prepared to act should the right circumstances present. Keep in mind the immortal words sung by Geddy Lee from the band Rush in the song “Freewill”:

“If you choose not to decide, you still have made a choice.”

Political Concerns

Naturally, until the results of the election are known, there will be uncertainty regarding the outcome and its impact upon the financial markets. Furthermore, should the results be close, the losing side may very well contest. Thus, the uncertainty of the outcome may last beyond Tuesday, November 3. Should the rates and municipal markets experience any volatility, we strongly advocate that financial professionals and their clients be poised to take advantage of any reasonably attractive spike in rates.

Concerns about the potential for higher deficits in the future with a Biden win have been floated, but we do not believe there to be much credible expectation for this to come to pass. Both candidates appear to have similar high deficit funding approaches. Additionally, worries about a fiscal aid package in the current COVID-19 environment (with flu season on the horizon) and negative impacts upon the economy could cause some volatility in the markets. Regardless of the reason for any uptick in rates, we believe the short-term fluctuation should present an opportunity for financial professionals and their clients to pick up yield that has been absent in the recent low yield environment.

Municipal Market Supply/Demand

Historically speaking, late fall has a reputation as being a time for caution in the municipal market, even in non-election years. This October has proven to be no different. In terms of new issue supply, it has jumped sharply higher than it was in October 2019; and weekly supply is greater than three times the average volume during this time period over the past three years. To be clear, most of the supply increase in 2020 has been in the form of taxable issuance with over four times the supply than last year. Tax-exempt supply is virtually unchanged on a year-over-year basis. The important point, however, is that average weekly new issue supply this month has been markedly higher.

Redemption cash (monies returned to financial professionals and their clients from coupon payments, or bonds maturing/being called) dipped noticeably in October; thus, reinvestment proceeds returning to the market are lower, depressing the demand side of the equation. All else being equal, if supply is higher and demand is lower, financial professionals and their clients can expect a cheapening market presenting the opportunity to invest at higher yields.

Municipal Market Ratings Action

Thus far, following the intense volatility in the market immediately following the COVID-19 shutdown, actions from the ratings agencies have increased dramatically; approximately 85% have been in the form of ratings downgrades. For context, in more stable environments, the split between upgrades and downgrades is usually much closer to 50/50. The process for the ratings agencies to perform a thorough analysis on individual credits is quite lengthy. Furthermore, with over 50,000 individual credits, it most certainly takes time to review a significant portion of the market. We would expect a continuation of this pattern of ratings downgrades as more issuers credit strength is evaluated.

What does this mean for municipal financial professionals and their clients? Essentially, we expect ratings downgrades to continue to impact the market. As issuers are downgraded, yields should rise for the securities impacted by those downgrades. Additionally, there could be some “follow-on” effects should financial professionals and their clients become concerned that more widespread downgrade activity could impact similar credits. Essentially, some financial professionals and their clients may sell securities into the market on fears about more widespread weakness. Selective purchases of such credits that have experienced unnecessary selling based upon fear, should be considered.

Potential Call to Action for Financial Professionals and Their Clients

In short, for a variety of reasons there could be notable and meaningful volatility in yields in the not-too-distant future. Whether price action moves significantly due to the political environment, technical factors or credit concerns, we believe financial professionals and their clients should remain indifferent and view volatility as a buying opportunity. To be fair, we do not expect volatility to be remotely close to that which was observed in the March/April time period. As has historically been the case, should this opportunity come to pass, we believe financial professionals and their clients should consider putting cash to work and lock in higher yields when the chance arises, as opposed to staying on the sidelines and potentially missing this chance. Remember, by deciding to do nothing, one is still making a choice.

CRN: 2020-1005-8607 R