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

  • Yield curve:
    Currently, the municipal yield curve is inverted (ie shorter-maturity yields are higher than longer-maturity yields), seeing the Securities Industry and Financial Markets Association (SIFMA) tax-exempt seven-day rate at +5.2% as of March 20, 2020.The last time this occurred the inversion lasted for only one week and quickly snapped back (with prices increasing) to more normal levels. This time the window may be open a bit longer due to economic uncertainty, but it’s truly difficult to say at this point. However, it’s important to remember the history of strong credit quality that municipals have demonstrated:
     
    1. BBB-rated municipal bonds (i.e., the lowest rating within investment grade) have essentially the same ultra-low default rate as AAA-rated (highest quality) corporate bonds.
    2. Investment Grade: Municipal default rates are less than one-tenth of corporate default rates.
    3. High Yield: Municipal default rates are one-third of corporate bond default rates.

      (Click on image to enlarge)

      Credit quality

      Source: S&P
  • Municipal-to-corporate bond yield ratios are at extremes:
    The graph below shows that in the last seven years when this ratio has exceeded its long-term average, then high quality municipal bonds tend to enjoy total returns of 5-10%. In the years immediately after the global financial crisis (GFC), municipals enjoyed annual returns around 15%.

    (Click on image to enlarge)

    Muni

    Source:  Bloomberg Barclays as of 3/23/2020

  • Government providing unprecedented stimulus: 
    The U.S. government is injecting approximately $2 trillion toward essential services like hospitals and transportation, with certain municipal bonds likely benefiting.
     
  • Federal Reserve Bank is providing unprecedented liquidity:
    On March 20, the U.S. government announced it would make an additional effort to support the U.S. municipal market in the form of $700 billion in loans via its Money Market Lending Facility. This was greatly expanded on March 23, with the Fed announcing unlimited quantitative easing or QE (i.e., bond buying), along with $300 billion in new lending programs to help all corners of financial markets, including municipals.
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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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