The municipal bond market is not supposed to be exciting, but it has certainly been a white-knuckle roller-coaster ride so far in 2020. Despite all the turbulence, if you are a holder of high-quality municipal bonds, the best thing you could have done so far — and continue to do — is to hold on.
Muni-bond trading basically froze up in March 2020 and yields spiked. During the turmoil in early spring, we held on to our municipal bond positions, as we realized that the lack of liquidity was likely to be short-lived. Since then, munis have recovered substantially. In fact, in May muni bond indexes gained between 2.5% and 3%, the strongest monthly return since 2009.
Even after this rebound, the yields on high-quality munis are still relatively high. While we are not looking to add risk to our portfolios given all the uncertainty still about the US economy, we think high-quality munis will endure current disruptions and provide both income and much diversification to high-net-worth portfolios.
***The muni bond market has stabilized. The Federal Reserve has provided a backstop for the muni bond market by buying municipal bonds directly from states and cities. This past week, the Fed expanded this program. Under the revised program, all US states will be able to have at least two of their cities or counties eligible for the bond-buying program, regardless of population.
With the Fed in the market, municipal bond prices have stabilized and risen. This has attracted investors again. Most muni bonds are held by US households, not pension funds and other institutional investors. Since mid-May, net asset flows into muni bond funds have been positive after investors fled the market en masse in March. The biggest improvement in pricing has been in high-quality bonds that mature within 10 years. This is the where our exposure to municipals is concentrated. Meanwhile, lower quality and more stressed issuers still sometimes struggle to find buyers. And we will not be venturing out to include those types of credits in our portfolios.
***Additional aid from the US government. The federal government has provided only limited direct aid to states so far, but more support is expected to be part of the next round of stimulus that Congress is now debating. Due to Covid-19, most states anticipate substantial revenue shortfalls for the current fiscal year (which ends this June for many) and for fiscal 2021.This makes it all the more important that the US Congress pass a new round of stimulus. Already, states and municipalities have started with layoffs and cuts to services. And this new round of federal help would go a long way to stabilizing state finances.
States and municipalities are also likely to benefit from future federal spending on infrastructure. Both Democrats and Republicans favor infrastructure investment, albeit through different approaches.
***Improved fiscal discipline at the state and local level. During the decade-long economic recovery, from 2009 through 2019, state tax revenue rose significantly along with reserve funds to be used during downturns, and states remained hesitant to borrow after the 2008 Great Recession.
To hold on to some of those reserves for future emergencies, many states have already started to cut spending and make other adjustments. Overall, state budgets are expected to post a total deficit of $185 billion in fiscal 2020, with this just about doubling to $370 billion in fiscal 2021 before coming down to $210 billion in fiscal 2022 (per the Center on Budget and Policy Priorities).
As a result, the credit ratings of certain municipal bond offerings are likely to be cut, as changes in revenue and spending continue across all sectors and worsen in the coming year. Moreover, with this level of financial disruption, weaker municipal credits become more likely to come under pressure and even default although we think that will continue to be the exception. Given the challenges ahead, we believe careful risk analysis and a high-quality bias are key for achieving the best results in municipal bonds.
Could this time be different given the ongoing effects of Covid-19 and social unrest? We believe that municipal issuers can and will take the steps they need to bring budgets in line and continue to pay their bills, despite the headlines. For example, the Seattle Times reported recently that the city was forecasting that Covid-19 could reduce revenues by between $200 and $300 million annually, which sounds dreadful.
However, if you consider Seattle’s budget for fiscal 2020 — $6.5 billion — that revenue loss totals just 3.5% and 4.5%. Not good certainly, but manageable. And the shortfall also doesn’t account for the city’s rainy day and emergency funds, which total nearly $128 million. We believe Seattle’s situation generally represents the condition of the muni issuers we are exposed to in our portfolios. State pensions do remain an issue in the longer-term, but the recovery in the markets since late-March has so far kept funding ratios from slipping.