Municipal Bonds: Volatility Is Creating A Potential Opportunity, But Choose Carefully

Until very recently municipal bonds were a very different experience, finishing 2019 with a 14-month run of positive net inflows2, equating $95 billion into open-end mutual funds and exchange-traded funds. 2020 is also setting flow records, although from an outflow perspective, with Friday, March 20, marking a one-week outflow record of $12 billion and possibly a month-to-date outflow record, with $27 billion so far. 

(Click on image to enlarge)

Lowest flow

Source: Morningstar Direct

Why are we experiencing this?

The massive sell-off is driven by the near term economic uncertainty presented by COVID-19, a pandemic that has driven wide-spread indiscriminate selling across all asset classes—including the municipal bond market, which is typically considered a safe haven asset class. Investors rushed to sell municipal bonds to raise cash, making these relatively less liquid (versus U.S. Treasuries) high-quality bonds extremely illiquid, driving mark-to-market price losses in funds. So March represented a liquidity crisis, not a credit or default crisis.  

What’s worth noting is that during 2019 of record-breaking inflows and limited supply, some of the larger municipal funds appeared compelled to purchase speculative non-rated (NR) issues that they otherwise may not have. Now, these funds are experiencing pressure to keep up with redemptions, selling their high-quality munis so as to not force-sell the less liquid NR bonds, exacerbating the price pressure on high-quality bonds. When buyers do start to emerge, they could potentially come from relatively smaller tax-exempt bond funds that are able to more nimbly navigate the selling pressure. 

Why municipal bond funds, why now?

The benefit of buying now is investing in bonds at attractive price points. Four main points to consider while contemplating an allocation of sidelined cash to municipal bonds come in the form of forward-looking expectations that may be hidden behind negative headlines:

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Disclosures

Quantitative easing (QE), also known as large-scale asset purchases, is a monetary policy whereby a central bank purchases government securities or other securities from the market ...

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