How to navigate U.S. municipals in a liquidity crunch
Don’t join the panic. Your guide to discerning investment in munis.
In the face of a COVID-19–led downturn and the worst liquidity crunch since the financial crisis of 2008, investors have been selling what they can, not what they want to. The $4.3 trillion U.S. municipal bond market locked up as investors looking to sell their securities for cash found themselves with no bids for their bonds.
We view the movement more as a liquidity squeeze than a credit concern, and favor holding and/or adding exposure. That said, some credits are more vulnerable to virus disruption and—with more than one million municipal CUSIPs available—it pays to be discerning.
This is what a municipal liquidity crunch looks like
Municipal bonds are traditionally quite low on the risk frontier, offering investors low relative yields in exchange for low relative risk.
But in late February, early March, that risk frontier framework collapsed, and investors may not be pricing risk rationally. Volatility has increased more for less risky asset classes, the opposite of what you might expect if credit risk was the only variable at play. Over the last 50 years, municipal defaults have been roughly 0.2% versus roughly 2.3% for investment grade (IG) corporate issuers.1
Suddenly, muni volatility skyrocketed
Source: Bloomberg Finance L.P., data from January 2006 to March 2020.
Bar chart compares performance of munis with US Aggregate, US IG Corp, BBB, Taxable Munis, US Corp HY, Preferreds, and SPXT, showing their 4-week volatility (as of March 20, 2020). Chart highlights that munis, which used to have the least volatility compared to this group, have experienced the highest level of volatility in recent weeks.
Enter stage right a liquidity crunch in which investors sought to sell what they could. Lipper reported combined weekly and monthly record municipal outflows of $12.2 billion for the period ending March 18. While alarming for municipal markets, record outflows were seen across the fixed income market complex.
Fixed income outflows broke records
Source: Bloomberg Finance L.P. JP Morgan, as of March 23, 2020
Bar chart shows the weekly flows (in USD billions) of high-yield bonds, munis, investment grade bonds and the Money Market index from January 2020 to March 2020. This highlights that in March 2020, all four have seen the largest outflows ever experienced during this time period; most affected have been investment grade bonds.
The liquidity crunch has been particularly acute in the short end of the municipal bond market. The variable demand note market rate (VRDN) rose above 5% by March 20. VRDNs help municipalities to manage operating cash needs, comparable to the way corporates use commercial paper. The extraordinarily high VRDN rates are a function of excessively high dealer inventories that have ballooned to levels not far from the all-time highs reached during the crisis of 2008–2009. As a result of this buildup, SIFMA rates were reset to the highest level since the 2008 financial crisis.2
Municipal bonds reach their cheapest valuation, relative to Treasuries, in 10 years
Since the start of 2020, the municipal yield curve has sold off approximately 140 basis points (bps), on average. The majority of this volatility occurred in March and culminated with a historic 50 bps selloff, across the curve, on Friday, March 18.
Municipal/Treasury ratios (a relative value tool to help determine richness or cheapness) are now at their highest since 2008—which suggests municipal bonds are at their cheapest level, relative to Treasuries, since the financial crisis.
Municipal yields march higher, led by short-dated maturities
Sources: Bloomberg Finance L.P. JP Morgan, as of March 23, 2020.
Two charts—one showing the expected municipal yield curve from now through 2049. The second shows the municipal/treasury ratio – the 30 year Tenor lines with a 3.37% muni yield, 1.55% treasury yield, and a 217% ratio.
What can you do?
Given this environment, here are some actions you might consider taking now within the fixed income market:
- Consider adding exposure to front-end municipal credits, as the Fed is offering a backstop to municipality liquidity needs. On March 23, the Fed announced that municipal credit is eligible for the Commercial Paper Funding Facility. Municipalities now can find short-term financing from the most creditworthy institution in the United States—at least through March 2021. The Fed also made municipal collateral eligible for the Money Market Mutual Fund Liquidity Facility. So mutual funds will have a place to sell collateral to meet municipal fund redemptions. It will take time for the liquidity to get through the system, but a backstop is now in place.
- Be discerning with longer-dated municipal credits. We do not believe any state is currently a default risk. That said, some municipal bonds are more susceptible to virus disruption than others.
Stay defensive and consider buying “Local GOs/School Districts.” These securities are supported by property taxes, which, generally speaking, should be more resilient and less volatile than a typical sales tax–backed bond.
Water & Sewer/Pubic Power fall into the essential service category, and it’s possible that certain jurisdictions may see an uptick in revenue as shelter-in-place orders generate more essential service revenue.
Conversely, you might want to avoid student housing bonds, given the systematic shutdown of universities. Student housing bonds that are located on satellite campuses or from smaller, lesser-known universities could struggle to meet their debt service payments. Also, bonds backed by either hotel occupancy taxes or stadium revenues could see their ratings decline and a number of bond impairments.
How we see the fixed income market now
Source: Bloomberg Finance L.P., J.P. Morgan, as of March 23, 2020.
Chart goes through our outlook for various sectors, and providing detail for our outlook. For example—our outlook on school districts is positive because property taxes are more resilient and less volatile vs. income and sales tax.
We can help
One added precaution: Take the time to discuss with your J.P. Morgan advisor any move you’re contemplating in order to make sure it is the right one for you now, and that it fits into your long-range wealth plan. We’re here to provide you with the information you need so that your decisions—buy, sell or hold—are well grounded in current as well as future considerations.
2 For those experiencing flashbacks to auction rate securities during the 2008 crisis, VRDNs are not the same. VRDNs have long-term nominal maturities but bear variable interest rates. (The most common type of VRDN has weekly interest rate reset.) Importantly, VRDNs have a put-back feature at par and don’t require an auction to liquidate (as auction rate securities do).