Making Sense of the Move in Munis

Last week was a wild one in the municipal bond market. Investors withdrew some $12.2 billion, marking the end of more than a year of inflows that saw $130 billion enter the market. Yields spiked as traditional liquidity providers retreated and some mutual funds and ETFs became forced sellers. Municipal yields rose to their most attractive levels relative to Treasuries since the great financial crisis – and prompted nascent signs of interest from banks and other institutional buyers.

Here’s our perspective on key questions facing municipal bond investors:

How has the municipal market been affected by broader financial market stress?

Last week, liquidity became severely challenged across global fixed income markets. By week’s end, AAA general obligation bond yields had increased by a historic 179–186 basis points across the curve, relative to February month-end levels, according to Thomson Reuters. With sharply higher yields, illiquid conditions, and heightened volatility, most municipal issuers opted to temporarily pull back deals that were set to come to market. Yet the increase in yields left municipals at their most attractive levels relative to Treasuries on record, and we began to see budding signs of interest from banks and other institutional buyers.

We believe the last two weeks were a temporary liquidity disruption and not a sign of fundamental credit weakness in the muni market. Of course, there are a few exceptions in sectors that may be directly exposed to COVID-19 – select ports, airports, airlines, and continuing care retirement centers (CCRCs) come to mind. Nonetheless, although we believe most municipal sectors and obligors will remain resilient even if the U.S. economy falls into recession, we have taken, and will continue to take, steps to de-risk portfolios from disproportionately affected obligors.

Why did liquidity dry up?

In the municipal market, an initial trickle of outflows morphed into a historic liquidity crunch on 19 March, as traditional sources of liquidity were unwilling (or unable) to buy bonds coming to market. Some mutual funds and ETFs facing redemptions became forced sellers, causing a sharp and sudden increase in yields. Outflows were substantial, totaling an estimated $12.2 billion in the week ending 18 March, concentrated in high yield mutual funds and ETFs, Lipper data show. The outflows marked the end of a-61 week cycle that funneled a net total of $130 billion into muni funds and ETFs, according to ICI data.

We had expected challenging liquidity conditions in the muni market based on trends that appeared to increase the probability that the municipal market was vulnerable to sudden bouts of illiquidity. For example: Due to strengthened post-crisis regulations, broker-dealers have significantly reduced their municipal bond inventories to about one-third of pre-crisis levels.