Five Points of Potential Resilience in the Municipal Bond Market | Lord Abbett
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Fixed-Income Insights

A Lord Abbett expert offers perspective on the municipal bond market in this time of heightened volatility and economic shock.

The impact of the COVID-19 virus on U.S. financial markets has not been a subtle one. Equity markets, taxable bond markets, and municipal bond markets have been tossed about in the sudden uncertainty that quickly took hold of investor sentiment.

Amid the ongoing market volatility, Lord Abbett investment professionals have stayed in close contact with advisors and investors to provide timely perspective on recent events and their impact on portfolios. On April 2, Lord Abbett Partner Dan Solender, Portfolio Manager for Municipal Bonds, held a Webinar for professional investors on developments in the municipal bond space. (Register here for a replay of the webinar.) Following are some of the key points Solender made to his audience.  

1. Muni revenues were at record high levels entering March 2020.

Heading into this storm, state and local governments were in a historically strong position in terms of revenues.

 

Figure 1. State & Local Tax Revenues Increased Over 40% from the Pre-2008 Financial Crisis Peak
State and local tax revenues (as of December 31, 2019)

Source: Census Bureau Quarterly Summary of State and Local Tax Revenues. Data indicate trailing 12-month revenue, calculated quarterly. Data are the most recent available.

 

Moreover, in the final quarter of 2019, nearly 40% of revenues were derived from the most consistent and stable of revenue sources for states and local governments – property taxes. Income taxes, both personal and corporate, accounted for 33%, and sales taxes, 28%. Historically, sales taxes have been the most susceptible to near term declines in consumption and spending.

Of course, we have no way of knowing how long the current economic shock will last. But we have seen extended periods of declining revenues before. Coming out of the 2008-09 financial crisis, you can see in Figure 1 that it took 12 quarters for revenues to recover to their previous highs. But in the decade since then, revenues have grown substantially.

2. States and municipalities are better prepared for financial stress than they were in 2008-09.

The lessons of the 2008-09 financial crisis also have been evident in the accumulation of “rainy day” balances – ensuring that the reserves would be stronger to prepare for more stressful times that may lie ahead.

 

Figure 2. Most States and Municipalities Increased “Rainy Day” Funds, as Median Reserve Balances Reached All-Time Highs
State and local tax revenues (as of December 31, 2019)

Source: Census Bureau Quarterly Summary of State and Local Tax Revenues. Data indicate trailing 12-month revenue, calculated quarterly. Data are the most recent available.

 

Consequently, state and local governments are better prepared to absorb at least some of the short-term falls in tax receipts that they are likely to experience. That is not to say that, coming into March 2020, they had raised all of the liquidity they would need over an extended period of time –after, all, we do not know how long this crisis will persist.

3. Congress is providing significant, direct economic stimulus funding to states and municipalities, and the U.S. central bank has vowed to support liquidity.

The U.S. Congress acted early and significantly to support the municipal bond space with the enactment of the Coronavirus Aid, Relief and Economic Security Act (CARES Act), signed into law on March 27. Figure 3 highlights some of the programs in the CARES Act with the greatest impact on states and cities – adding up to $280 billion of direct stimulus to municipal bond issuers.

In addition, the U.S. Federal Reserve (Fed) stands ready to purchase short maturing investment grade municipal bonds in the open market, providing an unprecedented level of support for liquidity in muni money market funds. As I mentioned on March 23, we’ve observed recently that banks, insurance companies, and hedge funds have become big buyers in the muni market. So liquidity, despite being costly at times, has been available when needed so far. I believe that the Fed’s impact, if it enters the market for bonds longer than one year, will be felt largely in the investment-grade side of the market, not in the high-yield sector.

None of these programs or measures was implemented during the financial crisis of 2008-09.

 

Figure 3. The CARES Act Provides $280 Billion of Direct Stimulus for Municipal Bond Issuers

Source: National Conference of State Legislatures.Covid-19 2020 Stimulus bill: What it Means for States, 2020.

 

4. Key municipal bond sectors are benefitting from the CARES Act, and there is talk of another bill to support infrastructure needs.

The amount and quality of federal support of the municipal bond market is, I believe, unprecedented. In my 30 years in this industry, through numerous periods of uncertainty and volatility, I have never witnessed anything like this. And the reasons for that support this time are clear to everyone.

Hospitals, senior care facilities, schools, and transportation sectors, including the airlines and toll roads, are not only vital parts of the U.S. economy, but also vital to our wellbeing as healthy and productive individuals. Unlike the global credit crisis, this time the economic issues have not been caused by any corporate entities, so the federal government has more interest in supporting areas of the market that are most affected. Many municipal bond issuers are at the forefront of responding to the country’s needs during this difficult time so there are plenty of reasons why the federal government believes it is right to support them.

5. Currently, municipal bond yields are higher than U.S. Treasuries, even without factoring in the benefits of tax exemption.

I’ve always believed in the value of municipal bonds over the long-term. For investors who can look beyond the current levels of volatility, this may be a good time to buy. One of the indicators of this is the municipal/Treasury ratio (M/T).

During typical environments, the M/T ratio is in the 70% to 80% range for shorter bonds and 85% to 95% range for longer bonds. A ratio that is in excess of 100% has typically suggested that there may be attractive relative value. This is because investors are receiving more income than they do with Treasury bonds before even factoring in the tax benefit of muni bonds, making them even more attractive for high net-worth investors with higher tax rate considerations.

Why invest in a taxable Treasury bond when you can invest federally tax free and maybe state and local tax free too at a higher yield? For example, during the 2008-09 financial crisis, the M/T ratio shot up to over 200% before settling down near its historical averages. Those who invested at that time made out well. And the ratio today is even greater than it was in 2008.

 

Figure 4. Muni Bond Yields are More Attractive Today Than They Were a Month Ago
Muni/Treasury Ratios (February 28, 2020 versus March 31, 2020)

Source: Thompson Reuters Municipal Market Data (MMD). Muni-Treasury Ratio =Municipal Bond Yield ÷ 10-Year Treasury Yield. The higher the muni-Treasury ratio, the more attractive munis are relative to Treasuries. Past Performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

In Conclusion

We've been through these periods of market volatility before; the muni market is getting more support this time than ever before; so, in my mind, the outcome is likely to be just as positive compared to what it has been in prior periods, particularly on the investment grade side.

Unemployment in “non-essential” service areas is high, but I believe the picture will brighten as we pass through this storm and most municipal bond credits will perform well as they have historically. In the meantime, revenue from income and sales taxes is still coming in from activity in many sectors of the economy that are still performing well and remaining profitable.  

Fiscal year ends for most states are June 30. But many states, in line with the IRS, are going to be pushing the date for filing required payments to July 15 and a few, like New Jersey, are thinking of changing their fiscal year end to September 30. With a functioning U.S. economy, this is revenue deferred, not revenue foregone, Municipal bond issuers likely will adjust their budgets, temporarily reducing things like capital spending and taking federal government support to bridge the gap during this time.

We don’t know how long the economic downturn will last, but we know that the federal government is giving substantial support to many municipal bond issuers, and we know that the municipal bond market has performed well coming out of these types of environments before. There is no certainty that it will again this time, but the market yields have risen to more attractive levels than they have been in a while and many actions have already been taken to fortify issuers through this challenging time.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Lower-rated investments may be subject to greater price volatility than higher-rated investments. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.  If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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