SUMMARY
- Municipal bonds rallied strongly in May, with $2.87 billion flowing into municipal funds. High yield credits were the month’s best performers.
- New municipal bond issuance was down slightly from April, finishing the month at $28.0 billion.
- May’s rally was aided by continued support by the Federal Reserve, which laid out additional plans to expand its Municipal Lending Facility throughout May and into early June.
- While nationwide protests could result in police overtime and increased public safety expenditures, we believe most high quality municipal issuers have the reserves to manage through near-term stress.
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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
Equities rose modestly in May on signs of economic recovery stemming from the early reopening of cities and states and optimism regarding COVID-19 vaccines in the pipeline. AAA Municipal Market Data (MMD) yields ended May at substantially lower levels than at April month-end. In particular, yields five years and in were down from 70 – 75 basis points (bps) at the end of the month, driving short-term yields close to zero, while yields beyond six years were down between 62 and 65 bps. The 10-year tenor ended the month at 0.84%.1 May total municipal bond issuance of $28.0 billion — approximately $5.3 billion of which was attributable to taxable municipal debt — came in just below April’s final tally of $29.4 billion, marking the second-lowest monthly issuance on the year so far.2
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The Federal Reserve continued to grow its balance sheet in May, most notably expanding its corporate credit facility via the purchase of corporate bond ETFs. The Fed also laid out additional plans for its forthcoming Municipal Lending Facility, a new emergency lending program for state and local government buyers, which it views as a “backstop, not a first stop” for municipal issuers.3
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Municipal bond indices were up in May following the biggest muni rally in a decade. The Bloomberg Barclays Municipal Bond Index returned 3.18% and the Bloomberg Barclays High Yield Municipal Bond Index returned 4.08%, bringing year-to-date total return for the two indices to 1.24% and -6.35%, respectively.4
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Muni/Treasury ratios decreased across the curve in May, most significantly on the short end. Though nearly all tenors of the curve remain above 100%, the one-year ratio ended the month at 65% (down from 476% at the end of April). The two-year ratio ended the month at 100% (down from 479%), the five-year ratio at 127% (down from 321%), the 10-year ratio at 129% (down from 235%), and the 30-year ratio at 116% (down from 180%).5
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Muni/Treasury taxable-equivalent spreads* also decreased across the curve in May. At month-end, spreads equated to two bps at the one-year tenor, 11 bps at the two-year tenor, 34 bps at the five-year tenor, and 77 bps at the 10-year tenor.6
Muni technicals in focus: Demand revives in the muni market
As the nation grappled with reopening from COVID-19 lockdowns and widespread unrest prompted by the death of George Floyd, markets showed signs of emergence during the month of May. Equities continued their upward trajectory, with the Dow Jones Industrial Average and the S&P 500 closing the month over 4.5% higher than last month-end.8 Following two straight months of negative returns for the municipal market, the Bloomberg Barclays Municipal Bond Index returned 3.18% and the Bloomberg Barclays High-Yield Municipal Bond Index returned 4.08% in May, the largest monthly gain since September 2009 for both indices.9
After a net ~$16 billion of municipal outflows last month, investors added net $2.87 billion to municipal funds in May, sending municipal yields plunging.10 From its peak of 2.79% in March, the 10-year AAA municipal yield descended to 0.84% this month.11 The rally was more pronounced on the front end of the yield curve, which was bolstered by support from the Federal Reserve.12 Notably, the Federal Reserve released pricing information for the Municipal Liquidity Facility this month, which was generally more favorable relative to market rates for eligible issuers with lower credit ratings.13 Credit spreads continue to widen, spurred by growing demand for high-quality credits. The BBB - AAA 10-year municipal spread has climbed from 61 bps in mid-February to 146 bps at month-end.14
May brought additional data points on states’ revenue outlooks. April tax revenue numbers showed state tax collection declines of over 25% from April 2019, although some income tax revenue is likely to be recouped as taxes are gradually filed.15 Early indications suggest significant declines in sales tax revenue, including Texas and New York reporting that sales tax revenues fell by 13% and 24%, respectively, from April 2019.16 While we expect continued headline risk, we continue to believe states will close the gaps with a variety of measures, including accumulated rainy-day reserves, spending cuts, federal CARES Act funds, and fund sweeps. California dominated attention with its revised May budget, which projects a $54 billion deficit across fiscal years 2020 and 2021. While the numbers are large, we note that the state faced a $60 billion two-year gap during the financial crisis, with far fewer internal tools available to close the deficit. As we approach July 1, we expect many states will opt to pass placeholder budgets until revenue trends become clearer. While some states such as Illinois and California have proposed budgets that rely on additional federal help, we expect these states to find additional budget solutions should federal support fail to materialize.
The end of May saw the outbreak of widespread protests across a variety of U.S. cities. While this may result in temporary increases in police overtime and public safety expenditures at a time when many local governments are already experiencing revenue losses from the pandemic, we do not expect any material impact on the credit quality of high-quality municipal obligors.17 We feel these obligors have the reserves and financial flexibility to manage through near-term stress. The longer-term impact of possible shifts in public safety and social service spending priorities could present difficult decisions for policymakers, but at this time we do not believe it poses credit risk for investors.
1 Thomson Reuters TM3 MMD Interactive Data, 29 May 2020
2 The Bond Buyer: Primary Market Statistics – A Decade of Bond Finance, 29 May 2020
3 Matthew Boesler, “Fed Continues ETF Buying, Signals Muni Lending Facility Imminent,” Bloomberg, 28 May 2020
4 Amanda Albright, “Biggest Muni Rally in Decade Drives Yields to Cusp of Zero,” Bloomberg, 27 May 2020; Bloomberg Barclays, 29 May 2020
5 Thomson Reuters TM3 MMD Interactive Data, 29 May 2020
6 Thomson Reuters TM3 MMD Interactive Data, 29 May 2020
7 SIFMA: US Municipal Trading, 4 April 2020; The Bond Buyer: Secondary Market Data, 29 May 2020
8 Bloomberg, 29 May 2020
9 Bloomberg Barclays Indices, 29 May 2020
10 Refinitiv Lipper, 29 May 2020
11 Thomson Reuters TM3 MMD Interactive Data, 29 May 2020
12 Ibid
13 Federal Reserve Release, “Term Sheet: Municipal Liquidity Facility,” 11 May 2020
14 Thomson Reuters TM3 MMD Interactive Data, 29 May 2020
15 Data from PIMCO analysis of 33 states’ April 2020 revenue collection data
16 Bloomberg, “Texas’s Sales Tax Plunge By Most in a Decade on Shutdown,” June 1, 2020; and New York State Comptroller’s Office
17 For example, the City of Minneapolis’ most recent audited financial statement show General Fund reserves that could cover 38% of total annual public safety costs
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 on 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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