SUMMARY
- As the global economy grapples with a recession caused by the COVID-19 pandemic, the AAA municipal yield curve ended notably steeper in April than at the end of March.
- New Federal Reserve lending facilities aimed at providing funds to banks, companies and municipalities represented an unprecedented use of its emergency powers.
- While municipal bond indices fell for the second straight month, losses were less steep than in March, and issuance increased slightly from March’s two-year low.
- Municipalities have proven resilient in past periods of fiscal stress, and while there is potential for cuts and revenue losses, we believe that high quality muni obligors will navigate through these difficult times.
IMPORTANT NOTICE: Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real-time market developments. All opinions are subject to change without notice.
Month in review
Following another volatile month as the global economy continued to grapple with a swift shift into recessionary territory due to the COVID-19 pandemic, the AAA Municipal Market Data (MMD) yield curve ended April notably steeper than at the end of March. Yields on the short end of the curve were down as much as 24 basis points (bps) relative to March month-end, with the one-year tenor down to just 0.81%. Yields on the long end of the curve were up as much as 29 bps, with the 30-year tenor up to 2.26%. The inflection point came at the five-year tenor of the curve, where the 1.09% yield figure from 30 April remained unchanged from 31 March.1 April total municipal bond issuance of $23.8 billion — approximately $4.3 billion of which was attributable to taxable municipal debt — showed a slight rebound from March’s $18.6 billion. Though March muni issuance marked the lowest monthly figure since February 2018, April reported the third-lowest over the same time period.2
- The Federal Reserve strengthened its efforts to support the U.S. economy, expanding quantitative easing programs and announcing numerous new lending facilities in an effort to provide funds to banks, companies, and municipalities in an unprecedented use of its emergency powers.3
- Municipal bond indices were down for the second straight month, though losses were of a lesser magnitude than in March. The Bloomberg Barclays Municipal Bond Index returned -1.26% and the Bloomberg Barclays High Yield Municipal Bond Index returned -3.37%, bringing year-to-date total return for the two indices to -1.88% and -10.02%, respectively.4
- As Treasury yields remained relatively flat while the muni curve steepened in April, muni/Treasury ratios decreased on the short end of the curve and increased on the long end. With ratios remaining elevated relative to pre-pandemic levels, the one-year ratio ended the month at 476% (down from 700% at the end of March), the two-year ratio at 479% (down from 482%), the five-year ratio at 321% (up from 295%), and the 10-year ratio at 236% (up from 196%).5
- Muni/Treasury taxable-equivalent spreads* also decreased on the short end and increased on the long end in April. At month-end, spreads equated to 120 bps at the one-year tenor, 135 bps at the two-year tenor, 150 bps at the five-year tenor, and 185 bps at the 10-year tenor.6
- While March experienced the highest secondary market trading levels since 2008, April secondary market trading remained elevated but to a slightly lesser degree. The month’s 892,000 total trades and $279 billion in par traded marked the second- highest figures since October 2018.7
Muni credits in focus: Municipalities feel the fiscal strain of the ongoing pandemic
With over 3.5 million reported cases of COVID-19 globally — including over one million cases in the United States — widespread instability persisted in April, leaving markets in a state of flux.8 Labor markets continued to experience turmoil, as American unemployment claims surpassed 30 million as of 25 April.9 The Dow climbed 5,750 points in April from its trough in March, but remained nearly 5,100 points below its mid-February peak.10
The Bloomberg Barclays Municipal Bond Index returned -1.26% in April, following a -3.63% return last month.11 While they edged downward from March, muni yields and muni/Treasury ratios remained elevated relative to pre-pandemic levels.12 Five consecutive weeks of muni outflows were briefly reversed in mid-April, though the month netted approximately $16 billion in outflows.13 The primary market returned this month, with several noteworthy deals and approximately $23.8 billion total in new muni issuance.14
While muni technicals seem to be cautiously veering in the direction of normalcy, the pandemic continued to present fiscal challenges to municipalities. In an unprecedented move, as part of its Municipal Liquidity Facility, the Fed announced that it will lend $500 billion to the largest states, cities, and counties by purchasing tax, tax and revenue, and bond anticipation notes out to 36 months to maturity.15 Nevertheless, we expect muni credit concerns to be the subject of headlines, with near-term worries focusing on state budgets and the estimated cumulative $650 billion in lost revenues across three fiscal years.16 Over 50% of the aggregate estimated budget gaps are projected for the 2021 fiscal year, which 46 states start on 1 July 2020. While 30 states have already approved spending plans for fiscal year 2021, we anticipate all states will revise their revenue estimates downward and consider a wide array of spending reductions to both close out fiscal year 2020 and close gaps for 2021.17
Despite a recent suggestion that state bankruptcy would be viable, we do not anticipate a wave of credit events within the high-grade portion of the municipal market and we believe implementation of state bankruptcy is highly unlikely. Further, investment grade municipalities have proven to be resilient, even during past periods of fiscal stress. During the global financial crisis, average default rates increased by only 0.07% to a very low 0.16% over the five-year period following 2009 — nearly 40 times lower than global corporate default rates over the same period.18 Despite high-profile defaults, such as Detroit and Puerto Rico, muni defaults remain extremely rare and investment grade defaults even rarer, which is a trend we believe will persist.
We expect there is strong potential for additional federal aid, though we continue to base our analysis on the conservative assumption of no additional help. In the absence of significant further federal assistance, we believe state and local governments will look to close budget gaps with spending cuts, internal fiscal measures such as fund sweeps and delayed payments, and potential tax increases. The cuts and revenue losses and corresponding budget solutions may be painful, but we continue to believe that high quality muni obligors will navigate through these difficult times.
1 Thomson Reuters TM3 MMD Interactive Data, 30 April 2020
2 The Bond Buyer: Primary Market Statistics – A Decade of Bond Finance, 30 April 2020
3 Christopher Condon, Craig Torres, and Steve Matthews, “Powell Says More Action Needed to Shield U.S. Economy From Virus,” Bloomberg, 29 April 2020
4 Bloomberg Barclays, 30 April 2020
5 Thomson Reuters TM3 MMD Interactive Data, 30 April 2020
6 Ibid
7 SIFMA: US Municipal Trading, 4 April 2020; The Bond Buyer: Secondary Market Data, 30 April 2020
8 Centers for Disease Control and Prevention (CDC), 3 May 2020
9 United States Department of Labor, 25 April 2020
10 Bloomberg, 30 April 2020
11 Bloomberg Barclays Indices, 30 April 2020
12 Thomson Reuters TM3 MMD Interactive Data, 30 April 2020
13 Refinitiv Lipper, 30 April 2020
14 The Bond Buyer: Primary Market Statistics – A Decade of Bond Finance, 30 April 2020
15 Federal Reserve Releases, 9 April 2020
16 Michael Leachman, “New CBO Projections Suggest Even Bigger State Shortfalls,” Center on Budget and Policy Priorities, 29 April 2020
17 “FY 2021 State Budget Status,” National Conference of State Legislatures, 29 April 2020
18 “US Municipal Bond Defaults and Recoveries, 1970-2018,” Moody’s Investors Service, 6 August, 2019
DISCLOSURES
A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
Forecasts, estimates and certain information contained herein are based pon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
PIMCO and Gurtin do not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. This market update was provided by Gurtin Municipal Bond Management, a PIMCO company (“Gurtin”). This material contains the current opinions of Gurtin and PIMCO. The commentary provided herein represents Gurtin’s assessment of the market environment at a specific time and the opinions and information stated and relied upon herein may become outdated, change, or otherwise be superseded at any time without notice. Certain information contained in this report is based upon third party sources, which Gurtin and PIMCO believe to be reliable, but are not guaranteed for accuracy or completeness. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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