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.
In addition, after the 2017 tax reform decreased the tax rate on municipal bonds to 21%, banks and insurance companies have found muni yields unattractive on an after-tax basis relative to high quality taxable securities. Finally, 61 straight weeks of mutual fund and ETF inflows led us to believe that at least some portion of muni holders represented fast-money investors who would exit at the first sign of trouble.
How is PIMCO positioning portfolios?
Based on our secular view of potential market disruptors, PIMCO generally had a bias toward caution, flexibility, and liquidity in managing our portfolios.
Related to municipal strategies, we favored credit quality and liquidity, and had selectively de-risked from credits that we felt had a higher correlation to equity drawdowns. As early news of the COVID-19 outbreak surfaced, we began exiting credits that we felt were at heightened risk. In addition, we increased exposure to cash and more liquid segments of the market across our suite of strategies. We believe this boost in liquidity will allow us to take advantage of potential opportunities as they arise.
What’s next?
Tax-exempt municipal valuations have cheapened dramatically in order to attract new capital, which has led to nascent signs of market stabilization. Direct retail buyers, along with banks and insurance companies, began to appear last Friday, leading to a stabilization in yields. Valuations are now historically cheap, with AAA muni/Treasury ratios above 210% across the entirety of the yield curve, according to Thomson Reuters. Further, AAA tax-exempt munis are trading at yields similar to AAA taxable corporates across the yield curve, according to ICE. Historically, relative value opportunities such as these have not persisted long.
Given the fluid macro backdrop and concerns around COVID-19, temporary bouts of illiquidity and continued outflows are likely to persist. However, we believe municipal bonds will remain a low-default asset class, and current valuations are an attractive entry point for long-term-oriented investors who can look through short-term volatility.
Policy responses to assist municipal issuers and improve market function may also play a role going forward. The Primary Dealer Credit Facility, announced last week by the Fed, should help improve short-term market conditions for eligible investment grade municipals. The Fed has also announced that municipal money market funds are eligible for liquidity support via the Fed’s Money Market Mutual Fund Liquidity Facility and that it had expanded the Commercial Paper Funding Facility to include municipal issuers. It is currently within the Fed’s authority to directly purchase short-term municipals, and a new proposal being discussed in the Senate could allow for longer-dated purchases. With long-term Treasury rates at record lows, income tax rates more likely to increase than decrease, and a demographic bulge of savers entering retirement, we believe the secular argument for munis remains as strong as ever.
© PIMCO
© PIMCO
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