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Fixed-Income Insights

In our view, the U.S. Federal Reserve’s Municipal Liquidity Facility may potentially offer important support for certain lower-quality municipal bond issuers—and thus, the broader market.

Read time: 13 minutes

After a difficult March, municipal bond prices started recovering in April in the high quality segment of the market, with the rebound subsequently extending to bonds in lower ratings categories as we enter June.  One of the turning points for the market was when the U.S. Federal Reserve (Fed) decided to find ways to extend support to municipal bonds, culminating in the creation of the Municipal Liquidity Facility (MLF), announced on April 9.  Now that the first municipal issuer to use this facility has been identified, it is worth taking a closer look at this new Fed program, and why it has been important in creating a positive outlook for municipal bonds.

What was behind the Fed’s move to create the MLF? The market was having liquidity issues due to large mutual fund redemptions, and all parts of the market were under stress.  While it was not a shock to see long bond yields rise substantially since they have higher liquidity costs for trading, it was surprising that the short term markets were also under pressure. The rates on municipal money market securities went from around 1% in February to more than 5% in late March, likely due to lower demand and short term concerns about credit quality. In response, the Fed’s first step was to buy these bonds from money market funds to lower funding costs for municipal issuers.  The rates dropped quickly, as can be seen in Figure 1; thus, the Fed’s maiden intervention in the municipal bond market was a success.

 

Figure 1. Intervention by the U.S. Federal Reserve Appears to Have Stabilized Muni Money Market Rates
SIFMA VRDN Index, February 1, 2020–June 3, 2020

Source: Bloomberg. Data as of June 3, 2020. VRDNs, or variable-rate demand notes, are floating-rate municipal instruments usually with long maturities (commonly 20 or 30 years), and carry a coupon that resets periodically. VRDNs typically have either a one- or seven-day put option which allows investors to put the security back to a financial intermediary (otherwise known as an agent) at par with one-or seven-days’ notice, respectively. It is this put feature at par that helps these securities be considered liquid investments and therefore eligible for purchase by U.S. money market funds.
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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A Liquidity Option for Lower-Quality Issuers

The Fed’s next step was to structure the MLF. What it ultimately decided to do was to allow borrowing in notes that could be used for maturities of up to three years. At first, the Fed decided to provide this to states and large local government issuers. Over time, this financing was made available to a larger number of local government issuers and, as of early June, a handful of revenue bond issuers.

As part of this process, the Fed did not want to replace what might be available to issuers who could access the market at reasonable yields that did not reflect stress. Thus, it based rates for the MLF notes upon issuer ratings and at yields which would be a penalty over rates available in the market.  As a result, borrowing rates under this facility likely do not make sense for most high-quality issuers and are only relevant for issuers who have more headline risk and need to pay high rates to build their liquidity.

What did the launch of the facility mean for borrowers of different credit quality tiers? Figure 2 shows what the MLF rates were as of the last week of May.

 

Figure 2. How Much Does It Cost a Muni Borrower to Tap the Fed’s Liquidity Facility?
U.S. Federal Reserve Municipal Liquidity Facility sample purchase rates as of May 27, 2020

Source: U.S. Federal Reserve. Data as of May 27, 2020.
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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

To put some context around how these rates compare to market levels, on June 3, Wisconsin brought a general obligation (GO) deal to the market.  Wisconsin is rated Aa1 (Moody’s)/AA (S&P).  The three-year maturity on their deal had a yield of 0.24%; borrowing from the Fed would have come at a rate of 1.75%. Obviously, Wisconsin chose to tap the public market.  Similarly, five-year bonds from California, with GO ratings of Aa2/AA-, traded at 0.64% on June 4; the Fed borrowing rate for a three-year term would be a much less attractive 1.80%. 

Since the municipal bond market has strengthened since the March volatility and is functioning well (see the rate rally in Figure 3), we think the Fed probably doesn’t have to do much more at this stage.  We believe its goal is to help issuers who are good long-term credits, but who may currently be forced by market conditions to pay far higher rates than their credit ratings would suggest, leading to potential stress in the market and on issuer finances.

 

Figure 3. Municipal Bond Yields Have Returned to Near Pre-Pandemic Levels
Thomson Reuters MMD 30-Year AAA yield, February 1, 2020–June 3, 2020 

Source: Thomson Reuters Municipal Market Data. Data as of June 3, 2020.
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. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Why Illinois Borrowed from the Fed Facility

So who was the first muni-bond issuer to kick the tires of the MLF? Illinois, whose fiscal stresses have been well documented, including this analysis in the Lord Abbett Muni Quarterly.  Illinois is rated BBB-, which is the lowest tier of investment grade and the lowest rating of any U.S. state. Despite its issues with pension funding, unpaid bills, and high borrowing costs, Illinois has never had trouble accessing the market; it just needs to pay much higher yields than other states.

As an example of its ability to access the market, Illinois brought a deal during the week of May 11 and the borrowing rate for the longest maturity (in 2045) was 5.85%, with rates for shorter maturities of 4.875% for one-year bonds, 5.125% for two-year bonds, and 5.375% for three-year bonds.  The MLF wasn’t ready yet, so the state decided to borrow at these rates.

Around the same time, Illinois tested the market for a much shorter-term note deal, but found that it would have to pay higher rates than it wanted.  Instead, it waited until last week when the Fed’s program started, and it chose to borrow from the MLF for one year at a rate of 3.82%.  Since the state didn’t opt to borrow for longer, it likely is expecting to attract better rates a year from now, in our view.

We think it is positive for the municipal bond market that issuers like Illinois can use the MLF.  Illinois has market access as it recently proved, but if the state can avoid borrowing at elevated rates during times of market stress, it can potentially steer clear of more severe future difficulties—and keep its credit rating from falling further.

Could the MLF Help the MTA?

What about borrowers in the revenue bond market? The New York Metropolitan Transportation Authority (MTA) has expressed interest in using the MLF.  The MTA recently issued bonds so it has market access, but given the headlines about reduced ridership on its transit lines amid the shutdowns in the New York area, its borrowing rates are higher than similarly rated issuers. (The MTA is rated A2/A-). When it tapped the market during the week of May 4, its longest bond was a 30-year maturity with a rate of 5.23%.  The 15-year bond in the deal came at 4.95%.  If the MTA could borrow for three years from the MLF, its rate would be about 2.55%.  So, like Illinois, the Fed can help this large issuer lower its borrowing costs and improve its budget situation.  In our view, the factors influencing the MTA and Illinois bonds are issuer-specific, as most investment grade issuers have no reason to use the Fed because the municipal bond market will allow them to borrow at low, attractive rates.

Summing Up

Amid the recent run of extraordinary events, muni-bond investors have had to contend with yet another remarkable development: the Fed’s efforts to support borrowers in a market that it had left untouched in prior crises, even in 2008–09.  Even before the emergence of the MLF, the market had begun strengthening on its own.  Should more issuers access the Fed facility, we think investors should not be concerned; rather, they should view such a development as a means of short-term support for a small number of issuers--and an important part of creating a more positive outlook for the broader municipal bond market.

 

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.

A basis point is one-one hundredth of a percentage point.

Coupon is the interest rate stated on a bond when it's issued. The coupon is typically paid semiannually. This is also referred to as the "coupon rate" or "coupon percent rate."

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return.

The risk-return ratio indicates the amount of yield an investor receives as a ratio to the amount of interest rate risk they are taking on.

roll-down return is a strategy for maximizing a bond's overall yield by exploiting the yield curve. It is dependent on the fact that the value of a bond converges to par as its maturity date approaches. The size of the roll-down return varies greatly between long- and short-term dated bonds.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points.

Standard deviation measures the dispersion of data from the mean. Applied to a rate of return, standard deviation is an indication of an investment’s volatility.

The tax-equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of the tax-exempt yield on a municipal bond. This calculation can be used to fairly compare the yield of a tax-free bond to that of a taxable bond to see which bond has a higher applicable yield.

The Securities Industry and Financial Markets Association VRDN Index is comprised of tax-exempt variable rate demand notes with certain characteristics. VRDNs are floating-rate municipal instruments usually with long maturities (commonly 20 or 30 years), and carry a coupon that resets periodically. VRDNs typically have either a one- or seven-day put option which allows investors to put the security back to a financial intermediary (otherwise known as an agent) at par with one-or seven-days’ notice, respectively. It is this put feature at par that helps these securities be considered liquid investments and therefore eligible for purchase by U.S. money market funds.

The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark yield curve creation.

The Bloomberg Barclays Municipal Bond Index a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.  Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies.  They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for 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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