Global markets have been grappling with the many unknowns of COVID-19, resulting in risk-off sentiment across capital markets. While municipal bonds were immune from the volatility initially, a massive demand for liquidity resulted in huge outflows from closed-end mutual funds and exchange-traded funds. Liquidity pressures were a function of investors rebalancing and a flight to quality, based on unfounded concerns about the fundamental credit of municipal issuers.
BNY Mellon Wealth Management's Fixed Income team believes that the current dislocations within this market will be temporary, aided by some of the recent measures put into effect by the Federal Reserve. We continue to believe that credit fundamentals remain solid and that this period of uncertainty has created opportunities.
Volatility and the Fed's Response
After a year of strong demand, flows into municipal-market bond funds have reversed in recent weeks. As a result, the price declines have been swift, causing yields to rise. In fact, we have seen investors' demand for additional yield over comparable Treasury securities increase to historic levels, exceeding those of the financial crisis. The ratio of 10-year AAA municipal yields versus 10-year AAA Treasury yields reached a peak of 365%, but now sits at 245% (see Exhibit 1).
There have been a number of measures put into effect by the Federal Reserve (with more likely on the way) to help support financial markets and the municipal bond market, in particular. The Fed's response has been massive, including cutting its federal funds rate to near zero and expanding assets purchases to roughly $1.5 trillion by reviving several programs developed during the financial crisis. One in particular, the Money Market Mutual Fund Liquidity Facility, gives the central banks the ability to buy short-term municipal securities. While it may take some time to work through the system, we are already beginning to see an improved state of liquidity within parts of the market. Within the dislocations, we are seeing attractive buying opportunities for intermediate, high-quality municipal securities.
Credit Quality of Municipal Bonds
Increased concerns about the virus' economic impact has raised concerns about the credit quality of municipal bonds, which we believe are unfounded. Coming into this crisis, municipalities were predominately financially strong. Given the past 10-years of economic growth, most states have built up strong reserves, allowing them to replenish rainy day reserves and putting them in a better position to withstand the effects of the virus. Many municipal issuers provide essential services, such as water, power and sewer, and are an integral part of everyday life. They have the flexibility to borrow inter-fund, which allows them to withstand the temporary revenue hits. In addition, municipalities have the backing of states and the federal government for financial support during difficult times. Compared to corporate bonds, credit ratings of municipal bonds are typically higher and empirical default rates are significantly lower.
Depending on how long this crisis lasts, we will see some short-term revenue disruptions on certain sectors including airports, elderly care facilities (nursing homes/CRCs), education and toll roads. But we expect those revenue deficiencies to be temporary, with municipalities able to rely on reserves, as well as state and federal support. The long-term fundamentals of municipal bonds remain intact and thus, we believe the ability to apply careful, rigorous research and credit analysis will enable us to identify buying opportunities in this environment.
What Should Investors Do?
Municipal bonds provide an important source of stability within a well-diversified portfolio. These assets provide tax-sensitive investors a source of income, yield and/or total return. As such, we believe investors should stay disciplined to their long-term allocations and not attempt to sell out of municipal bonds during this time of uncertainty.
Measures introduced by the Fed, as well as stimulus from the government will provide the municipal market with additional liquidity and support for any short-term revenue loss. We believe this virus-induced volatility will not impact the solid, long-term fundamentals of municipal bonds. We recommend that investors who are seeking liquidity be patient as these periods of dislocations are usually temporary. Even as markets are beginning to return a normal state, we see ample opportunities for value in this time of uncertainty.