Amid signs of a pickup of new bond issue supply in the municipal bond market, two recent deals have caught our eye. They were brought to market by issuers who have been the subject of negative media headlines: the New York Metropolitan Transportation Authority (MTA) and the State of Illinois. Both deals were heavily oversubscribed; that high demand enabled the issuers to lower their borrowing yields during subsequent repricings.
What’s going on here? We thought it would be useful to discuss why the market sees value in these bonds, despite some of the negative perceptions about the issuers.
New York Metropolitan Transportation Authority (MTA)
The MTA brought a deal during the week of May 4, with a range of different maturities, the longest one having a yield of 5.25% with a maturity of 2055. Despite recent alarmist headlines about ridership declines amid the pandemic, the MTA has ratings of A2 from Moody’s and A- from Standard & Poor’s. Both ratings carry negative outlooks, meaning they have the possibility of being downgraded, but they are well in the investment grade range; the next potential reduction would be to the BBB category—still investment grade. In our view, the MTA has a solid balance sheet with a good amount of cash, very strong government support, and the advantage of being a near monopoly on providing mass transit for the largest U.S. city.
To be sure, the New York shutdown has resulted in more than a 90% drop in the volume of transit system usage. Still, many may not realize that the CARES Act provides funding for transportation systems including the MTA. As the New York City area reopens, many suburban commuters may switch to driving, but there is no real substitute for the MTA’s extensive system of surface and underground transportation. Additionally, the government has been trying to reduce the volume of cars on the streets. A large system like MTA continually has capital projects and maintenance expenses that need to be financed, so it needs to maintain market access. All of this explains why the rating agencies and market participants do not concur with the dire forecasts offered by some observers.
Leading up to the new bond issue, MTA bonds had seen falling prices and rising yields. As Figure 1 shows, last year at this time a 30-year MTA bond had a yield of about 3%. Before the pandemic disruptions, the yield on that same bond had fallen to about 2%. At the worst point of the virus selloff, the yield rose to over 5% and then settled in around 4.75%. The size of the MTA’s May bond offering meant that the deal had to come to the market at a higher price. After the deal came to market, all MTA bonds rallied and the yield on this bond has fallen to 4.39%. At the same time, the new bond issued by the MTA which was originally priced at 5.25% has rallied to a 4.40% yield as of May 18.
Figure 1. MTA Bonds Stabilize after a Bumpy Ride in March
Yield on 30-year bond issue from New York Metropolitan Transportation Authority, May 15, 2019-May 15, 2020
Source: Bloomberg. Data as of May 15, 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.
So not only did the market accept a large amount of bonds when the new issue sold, there has also been a big rally since that time largely due to the positive market reaction to investors’ willingness to invest in the MTA.
State of Illinois
One week after the MTA deal, Illinois came to market with $800 million of general obligation bonds. Comments from Senator Mitch McConnell about possibly allowing U.S. states to declare bankruptcy rattled the broader muni market and probably led to higher borrowing costs for Illinois and other issuers. Fortunately, Illinois was patient finding the right borrowing cost and was able to raise the money it needed. The longest bonds had a maturity of 2045 and a yield of 5.75%. Since the deal was priced, these bonds have already rallied to a yield of 5.28% within a couple of days. Illinois is rated Baa3 by Moody’s and BBB- by Standard & Poor’s; S&P has a negative outlook, meaning the rating could be dropped to below investment grade.
Illinois, of course, has had well publicized financial issues. Over the past couple of years, the rating had stabilized because the state had created new revenue sources, managed its budget better, and started making full pension payments. Now, with the economic downturn from the virus, the future is less clear. Illinois has to find ways to cut its budget since tax revenues are falling. Meanwhile, political squabbling is putting the timing and amount of aid from Congress in doubt. Questions are arising about whether the state will fully make its scheduled pension payments. This uncertainty has led the yields on Illinois bonds to rise amid concerns about a possible rating cut to below investment grade in response.
As we have explained, bankruptcy or default is not an option for Illinois. The state also is required to have a balanced budget, which means expense cuts must go along with revenue declines. Note that interest payments are not a large enough portion of the state budget to materially change its financial standing even if it chose to skip them. It is in Illinois’ interest to continue making payments on its debt in order to ensure future market access because the state continually has capital projects that need to be financed and alternative sources would be much more expensive if they are available.
We think it’s useful to look at the volatility in the yield of Illinois bonds in the secondary market. Figure 2 shows the yield change in one of its recent long bonds. A year ago at this time the bond yielded just under 4% and had rallied to below 2.50% back in February. After the first market disruptions from the coronavirus, the bond’s yield had risen to about 6.5% at its worst moments in late March. The bond was priced around 5.75% prior to the deal and now has a yield of 5.47%. The move in yields, while somewhat volatile, shows that the outlook for Illinois’ credit prior to the virus induced slowdown was actually improving.
Figure 2. Yields on Long-Term State of Illinois Municipals Signal Improved Investor Demand
Yield on representative long-term municipal bond issued by State of Illinois, May 15, 2019-May 15, 2020
Source: Bloomberg. Data as of May 15, 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.
As mentioned before, after working hard to develop investor interest, Illinois priced its long bond on its new issue at a 5.75%. As soon as the new bonds were free to trade, they quickly rallied and settled at a yield of about 5.28% on investor relief that the issue was successful. For now Illinois will remain a low quality issuer, but it is clear that it has market access.
Echoes of 2008-09?
Comparisons of the muni market’s current situation with the 2008-09 financial crisis have been plentiful. Yes, the economic slowdown and unemployment rates are much worse this time, but the culprit is clear: COVID-19. As states and localities gradually reopen, the duration of the current economic slowdown should be much shorter, in our opinion. Also, in 2008 the U.S. credit system was collapsing, without a clear sense of the extent of possible government support. That is not happening this time; the CARES Act has already been providing funding to state and local governments. We think Congress ultimately will provide additional money.
The Federal Reserve (Fed) has started buying municipal money market securities and it is discussing plans to buy notes from state and local governments to give them another source for funds. The Fed is also considering the possibility of making open market purchases of municipal bonds. The outcome of these discussions is uncertain, but the ideas were never even proposed in 2008.
Even if the Fed does not get involved, this time around the market has been recovering much faster and borrowing rates are much lower. For example, there were no new municipal bonds issued during the last few months of 2008, and the only issuers to be able to access the market in early 2009 were ones that were rated AAA such as Harvard University and Massachusetts Institute of Technology. Even though they were highly rated, their borrowing rates were over 6%. This year, the State of Illinois and MTA have been able to borrow in the market within just about a month of the worst moments and at much lower yields even though they are lower rated.
Summing Up
Negative sentiment aside, we believe the municipal bond market is operating well as it awaits more support from the Fed and Congress. The market had provided access to high-quality issuers since late March, but as the MTA and Illinois deals show, financing is now available for other types of issuers as well. We think these two successful new issues should be an encouraging sign for the market outlook for municipal bond investors.
Chart of the Week
While the Fed decides whether to become more extensively involved in the muni market, it has already been quite active in purchasing U.S. Treasuries and corporate bonds. This imbalance has become evident in the ratios of municipal bond yields to both Treasury and corporate bond yields, which have become much higher than normal. As can be seen in this chart, for all maturities, the AAA benchmark yields for municipals are higher than Treasury yields for all maturities before even factoring in the tax exemption of municipal bond interest.
Muni-Bond Yields Are Higher than Treasures at All Points on the Yield Curve
One-month to 30-year yield curve for the indicated categories as of May 15, 2020
Source: Bloomberg and U.S. Treasury Dept. Data as of May 15, 2020. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
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 and expenses, and are not available for investment.