These are trying times for state and local governments. Unemployment is rising, revenue is falling, and investors are—understandably, in our view—treading carefully when it comes to municipal finance. But when we look beyond the headlines, we still see a lot to like about the municipal bond market.
While the pandemic adds uncertainty to the investment outlook, we think it’s important to stay focused on municipal bond credit fundamentals and current market valuations.
Credit Quality: Still Strong
Start with the fundamentals: We believe the broad credit quality of investment-grade municipal debt is still sound, partly because it is connected with the critical nature of the services that local governments provide.
Municipalities have benefited from diversified revenue streams, federal support and budgetary discipline. Budgetary discipline includes generally ample liquidity, relatively speaking modest debt levels and the ability to raise revenue and cut spending as necessary. And the sovereign powers of US states along with the taxing authority of municipalities have helped to bolster fiscal strength. This may be why municipal credit has been resilient during past economic shocks.
Let’s take a closer look:
■ Diversified Revenue Streams1: Municipalities are supported by various non-correlated revenue sources that can boost their resilience throughout economic cycles. State government revenues come primarily from sales taxes, personal income taxes and Federal grants. Local government revenues rely primarily on a combination of property tax and state aid payments. During recessions in 1990, 2001 and 2008, property tax collections increased for a full year even as the economy contracted.
■ Federal Support1: Federal aid to states and municipalities—another diversified revenue stream—increased during past crises. During the Great Recession of 2008-2009, New York and California saw declines in tax revenue yet benefited from transfers of federal aid. With the current economic dislocation, significant support from Congress through the CARES Act and the Federal Reserve’s Municipal Liquidity facility offer greater than $750 billion of support, and there may be more on the way.
■ Budgetary Discipline2: Municipalities have various tools, including broad taxing power, to shore up revenues. Many began March 2020 in their best credit health in a generation, with median rainy day fund balances the highest in history at the start of the fiscal year. Additionally, the largest municipalities, cities and counties with populations greater than 500,000 boast an impressive average general fund balance of 31%, a significant buffer against declines in revenue brought-on by COVID-19 and state-wide economic shutdowns. And states can also tap the bond market to shore up budgets. In 2009-10, California issued debt that was paid down by a special tax. As a result, debt as a percentage of gross state product, debt held at just above 4%.
Overall, we think high-grade municipal credit will be able to weather the current crisis. Will there be downgrades? Maybe. However, we think outright defaults will be few. Some sectors may be more susceptible than others. But we believe diligent credit research can help long-term investors to identify potential opportunities and seek to avoid risks.
Munis are on Sale - But Probably Not for Long
Here’s another thing to consider: municipal bonds are inexpensive today relative to history and may offer attractive income potential on an absolute and tax equivalent basis. As of 5-11-2020, the average yield on two-year municipal notes was 3.53 times above the yield on a comparable US Treasury—and that’s even before considering the tax benefit of owning munis. Furthermore, ten-year municipal bond yields were 1.56 times higher than ten-year Treasury yields.3
After rising sharply in mid-March, AAA-rated municipal yields have declined considerably. But medium grade (single-A and BBB-rated) securities and lower rated below-investment grade municipals have much wider spreads, and even here, we think an active approach may uncover value.
For instance, yields on BBB-rated municipal bonds from issuers hit hard by COVID-19—hospitals, toll roads, airports and transit systems—have risen sharply. The index yield for this group has hovered around 4% in recent weeks, a jump from 1.81% at the end of February. BBB-rated municipals even offer an income advantage relative to BBB-rated corporate bonds—the largest since 2013. Given the relatively low historical default rate of BBB-rated municipals, we believe the income advantage in this sector is potentially attractive.4
Credit spreads have widened and yields have jumped in the high-yield municipal market, too—from 3.29% at the end of February to as high as 5.67% in recent weeks. Even in today’s uncertain environment, we think careful investors who do their homework may find potentially attractive income opportunities here.4
More than $100 billion of munis will likely either mature or be called over the summer. While this extra cash will likely help support market technical factors, it may also make valuations less attractive. In our opinion, valuations and yields within the municipal market are attractive at current levels and uncertainty remains regarding how long this potential opportunity will last.