There’s been a rush to safety in the past weeks, which has benefited US high-quality bonds and hurt US stocks. However, in this recent bond rally, Treasury bonds have performed a lot better than municipal bonds (aka munis), which may be puzzling to investors. So far this year (through March 17), tax-exempt munis are down 1.7% vs. a 1.8% gain for high-quality taxable bonds, with most of the underperformance occurring in March. Given the prominent role muni bonds play as an anchor in high-net-worth portfolios, I thought I would write a bit about what is going on.
First, let’s consider what has happened to yields (which move in the opposite direction of bond prices). AAA-rated muni bonds maturing in 2025 are now yielding twice as much as comparable Treasuries: 1.6% pre-tax vs. 0.7% for five-year Treasuries. The 200%+ difference in yields is unprecedented, making AAA-rated munis seem like a bargain.
There are two main reasons for relatively high muni yields:
#1. Credit Concerns
Municipal bonds do have credit risk, as the creditworthiness of municipal bonds does vary greatly — anywhere from AAA (the highest quality) to unrated. When times are fair to good, munis often perform as well as high-quality taxable bonds, and usually better on an after-tax basis, especially for investors in the highest income tax brackets. Even during stock market selloffs, municipal bonds often perform just about as well as Treasuries. But a great deal depends on the cause of the market drop. If investors see a threat to the credit markets, as there might be given the economic impact of COVID-19, munis can get caught in the crossfire.
Is there any reason to question municipal credit today? Municipal issuers are certainly facing headwinds, and some states and sectors more than others. State and local GO issuers are on the front lines of dealing with COVID-19. Investors are concerned about budgets as spending increases to limit and treat the virus, while tax and other revenues are likely to fall.
On the revenue side, sales taxes and specialty taxes on things like gasoline and tobacco, are likely to drop, and even essential service revenues from water and electricity bills could be pressured. Are we expecting investment-grade municipal defaults? The short answer is no. Munis remain a very high-quality asset class, and we do not currently see long-lasting deterioration in credit risk/fundamentals.
For the most part, municipal issuers have made great strides since the financial crisis to shore up their finances. The disappearance of municipal bond insurance (paying to get a higher rating) and a standard credit rating scale have greatly improved transparency. There are some sectors such as health care, senior living facilities, and transportation that will see persistent stress but those issues are likely to be transitory. The most vulnerable space in the market will be high-yield (non-investment-grade) muni bonds, which we avoid in our portfolios.
#2. Lower Market Liquidity
Munis are held mostly by individual or “retail” investors, not institutions like pension funds or endowments. Retail investors tend to be more skittish during market downturns, and recently they have been selling munis. At the same time, the banks and broker/dealers that trade muni bonds aren’t interested these days in adding much risk of any kind, preferring to shore up their balance sheets. Many of these dealers are likely working from home and may want to clean up their balance sheets before quarter end. In any case, this lack of ready buyers has caused prices to move down, but we do not think this recent selling is indicative of what we think are relatively sound fundamentals.
For the relationship between muni and Treasury yields to normalize (muni yields are again closer to Treasury yields), Treasury yields have to stabilize first. Stable Treasury yields would bring back some appetite from muni broker/dealers and go a long way toward improving liquidity within the muni market. Once that happens, munis will be very compelling both pre- and post-tax, and demand should return fairly dramatically. So, the long and short of it is that we aren’t reducing our muni positions. That said, we are also not adding to our muni positions at this time, since return to muni normal could take some time. Additions to our core fixed-income holdings lately have gone into taxable bonds, as we recognized the likelihood of continued municipal bond underperformance in the near term.