A move of that magnitude in such a short period of time is extremely rare for the muni market. Basically, munis are feeling the impact of COVID-19 on two fronts. First, this is a unique trading environment in which liquidity is strained. Second, there are longer-term concerns about the impact that a sudden and severe slowdown in economic activity could have on municipalities’ finances.
Year-to-date muni returns have quickly reversed course
Source: Bloomberg Barclays Municipal Bond Index, as of 03/16/2020
Past performance is no guarantee of future results.
Liquidity has receded
There are a couple of factors that are contributing to the limited liquidity in the muni market. First, muni mutual funds experienced their first week of fund outflows after experiencing 50-plus straight weeks of inflows. In certain circumstances, this means that some fund managers may have to sell munis to meet clients’ redemption requests, driving down prices. This type of forced selling may not be necessary for other fund managers if they have adequate cash or other investments to meet redemptions. However, redemptions mean less demand for munis.
Second, longer-term concerns about the direction of interest rates due to the spread of the coronavirus have resulted in a limited number of buy offers, or bids, or have resulted in bids that are much further away from the market than expected.
Credit concerns have risen
Consumers are likely to stay home as they follow social distancing recommendations to slow the spread of COVID-19. Recent stock market declines also are likely to weigh on consumer activities, as people likely will cut back their spending amid fear of an economic slowdown and job layoffs.
While we don’t expect widespread municipal bond issuer defaults due to COVID-19, we do expect the decline in consumer activity to have an impact on some municipalities’ finances. This impact will be felt especially hard by issuers in certain sectors with already lower liquidity.
Although all muni issuers should not be painted with the same brush, here is the potential impact on some sectors of the muni market:
- State governments: Generally speaking, the largest sources of revenue for states are personal income taxes, sales taxes and governmental transfers. Some revenues, like sales taxes, are likely to suffer more the longer people remain worried about contracting the coronavirus. This poses a risk for states with already lower liquidity levels. However, President Donald Trump’s recent declaration of a national emergency opens up a range of assistance programs that should help with the financial burden of identifying and mitigating the impact of the virus.
- Local governments: We expect the finances of local governments that are reliant on sales taxes to suffer more the longer coronavirus concerns persist. Issuers that are more reliant on property taxes will feel the impact to a lesser degree, in our view. We don’t think the virus will affect property values, and therefore property tax revenues, in the near term. Depending on how the equity markets perform for the rest of the year, some local governments may be faced with higher pension costs. This too could pressure their finances.
- Hospitals: Increased hospitalizations could pressure high-occupancy hospitals and potentially crowd out other services. Supply chains for drugs and medical devices could also be negatively affected. The health care sector already tends to be lower-rated, on average, compared with the rest of the muni market, so we would suggest further caution here.
- Airports: Demand for airline travel has slumped recently, causing airlines to reduce capacity and posing a risk to airports. Due to COVID-19, Moody’s recently revised its outlook on the sector to “stable” from “positive.” However, most U.S. airports tend to benefit from fixed revenues, and should be able to manage through declines in demand. Historically, other outbreaks (SARS, for example) haven’t led to ratings downgrades. However, if concerns about the coronavirus linger and severely curb travel demand, this could result in downgrades. Larger, established airport systems that are in high demand should be able to manage better through the disruptions.
- Colleges and universities: Many colleges and universities already have moved to an online format for the remainder of the 2019-2020 school year. This is unlikely to affect near-term revenues, but enrollment could be hurt if concerns about the virus linger. Schools that are reliant on foreign students will be affected to a greater degree than those with a more diverse student mix.
What to consider now
Market volatility tends to underscore a few important points. First, you should have a financial plan. A financial plan helps you avoid panicking, or simply being forced to sell in a down market.
Second, consider your liquidity needs prior to investing. Individual bonds can be a useful cash-flow planning tool because they have set maturity dates. On the other hand, exchange-traded funds (ETFs) and mutual funds generally offer better diversification and may also employ an active manager. One is not superior to the other.
Finally, despite the concerns described above, consider adding munis to your portfolio now. Those concerns have driven muni yields to a level that is attractive, in our opinion. The 10-year municipals-over-bonds (MOB) spread—which compares the yield on a AAA-rated muni to that of a Treasury before accounting for taxes—has risen to the highest level since the 2008 credit crisis.
The 10-year MOB spread has surged due to fears of the coronavirus
Source: Bloomberg, as of 3/16/2020.
We think that some concerns about the slowdown in economic activity are justified, but overall we don’t expect widespread defaults. As of March 16, the media is reporting that Congress will provide fiscal support to help local municipalities. It’s unclear what that would look like at this point, but it would likely help soften the financial blow. We think higher-rated issuers (AA and above) should have the financial flexibility and resources to manage through a temporary downturn.