After some wildness, the municipal bond market has posted strong overall returns in last few weeks. Investment grade municipal bond returns are positive for 2020.
Technicals are balanced, considering above-average supply and continued inflows to muni mutual funds. The markets appear to be at least stable, if not rising, on higher comfort levels with potential U.S. state budget shortfalls. The states are demonstrating that they have vast flexibility to address these issues.
When coupled with present and possible future federal aid, municipal bond investors are optimistic about the ability of state and local entities to withstand the pandemic downturn.
Last week AAA municipal yields moved modestly higher in intermediate and long maturities. The Bloomberg Barclays Municipal Index was unchanged, while the High Yield Muni Index returned 2.12%.
Robust Fund Flows: For the fourth consecutive week, municipal mutual funds reported inflows ($1.2 billion). Long-term funds added $349 million; high yield funds had a second positive week, at $195 million; and intermediate funds had inflows of $125 million.
Still, challenges persist, as year-to-date municipal fund net outflows now total $16.6 billion.
Strong Supply: The muni market recorded $10.4 billion of new issue volume last week, up a healthy 21% from the prior week. Year-to-date issuance – $162 billion – is 24% above 2019’s pace. This is driven primarily by taxable supply exceeding last year’s levels by over three times.
Another $10 billion or so is expected to be issued this week, led by $3.5 billion of DASNY Revenue Anticipation Notes and an $800 million taxable University of Michigan transaction.
State & Local Governments Suffering: The economic damage of the pandemic has been most keenly felt by state and local governments. Already challenged budgets are bearing the brunt of health care and economic support, while income and sales tax revenues fall or even crash. States were not in equal standing coming into this crisis, nor are states equally affected.
Screaming headlines about budget shortfalls can be unnerving for municipal bond investors, but we believe the states will survive despite the tremendous challenges they face in combatting the COVID-19 pandemic. Healthy reserves, continuing federal support and robust management tools should enable even the most troubled states to prevail during these unprecedented times.
The yawning budget gaps of some of our biggest states have roiled the headlines, but New York, California and Illinois have the tools they should need to address their challenges.
What will happen in the wake of these economic and fiscal emergencies is a major concern. To deal with prior contractions, some states instituted strict austerity measures. While that may help them to meet their short-term financial obligations, austerity may not be supportive of the growth and reinvestment that many suddenly hard-hit communities will need – possibly desperately.
Funding from the U.S. Congress will ultimately inform how much austerity will be required. While Congressional action awaits, the U.S. Federal Reserve helpfully expanded the eligibility of its $500 billion Municipal Liquidity Facility (MLF) to municipalities of all populations. It also carved a path for certain revenue-backed liens to access the facility.
Loosening MLF standards highlights the Fed’s willingness to ease borrowing pressures on state and local governments. This should also extend the ceiling on short-term borrowing rates to large revenue issuers. For stressed municipalities with cash needs, the MLF can provide funding relief and extend near-term liquidity challenges to the medium term – but it is not a forgivable loan, nor will it cure structural challenges for some municipal entities.
Even with these moves, we remain cautious on municipal issuers that are downstream entities and either highly reliant on state funding or could potentially be judged non-essential in nature. Austerity measures could impact these credits especially adversely, making them a risky bet.
Thorough underlying credit analysis is critical when considering allocations to the municipal bond market. As active market participants, we are comforted by state revenue flexibility and the unprecedented support the municipal market likely will receive. There are ample winners to be found in muni bonds, but as ever investors should dig deep, judge carefully and purchase wisely.
IMPORTANT INFORMATION
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
© 2020 Legg Mason Investor Services, LLC. Member FINRA, SIPC. Legg Mason Investor Services, LLC, and Western Asset Management are subsidiaries of Legg Mason, Inc.
Read more commentaries by Western Asset Management
