April 2, 2020
Municipal and Corporate Bond Market Updates
There have been disruptive flows in fixed income markets in March. Investors are concerned about the state of the bond markets. This article will give our current thinking on the municipal and corporate bond markets.
Municipal Bonds – Disruptive Outflows, Some Opportunities, & Pockets of Credit Concern
Municipal bonds are generally considered lower-risk investments and are used for stability and tax-advantaged income in client portfolios. However, in March, there has been unprecedented volatility in municipal bond prices. We believe that (1) the primary factor of this volatility is technical, not fundamental, (2) current prices represent an attractive value compared with other high-quality fixed income markets, but (3) there are pockets of concern for issuer credit quality, but that overall, default rates on the municipal bond market as a whole should remain low and well-diversified portfolios should experience minimal credit losses.
Background on the Municipal Bond Market
The municipal bond market is large, fragmented, high quality and typically less liquid than other parts of the investment grade market.
- Large: the size of the municipal bond market is roughly $3.8 trillion.
- Fragmented: Across the 50 states and 5 territories, there are over 50,000 issuers of municipal bonds. Issuers range across a variety of sectors, including:
- State governments,
- Local governments, like cities, counties and school districts
- Various other governmental and non-profit entities providing transportation, water & sewer, utility and health services to citizens.
- High quality: The average rating of our municipal bond index is AA, and only 8% is rated BBB. Historically, from 1970-2016, investment-grade rated municipal bonds had a 10-year cumulative default rate of 0.09%, compared with investment-grade corporates at 2.38%, 26 times lower.
- Less liquid: About 50% of bonds do not trade much three years after they have been issued. Many buyers are ‘buy-and-hold’. Retail investors are a larger portion of the investor base than in other investment grade markets. Other investors include financial institutions like banks and insurance companies. More recently, ETFs and Mutual Funds comprise a larger portion of the investor base as well.
Simultaneous shocks to the market
The municipal bond market is grappling with several simultaneous shocks, including:
- State actions to combat the COVID-19 outbreak. As of Saturday, March 21st:
- All states and territories have declared a public health emergency.
- All 50 states have closed schools,
- 28 states have mandatory and 14 states recommended, limits on public gatherings.
- California, Connecticut, Illinois, and New York have “stay at home” orders.
- 35 states have limited or closed non-essential businesses, especially focusing on restaurants and bars.
- State, local, and healthcare system expenditures related to (1) treating a spike in patients, (2) supporting businesses impacted by government-mandated closures and (3) social safety net expenditures for workers who lose jobs due to COVID-driven economic disruptions.
- Exceptionally low oil prices (currently $21.55/barrel for West Texas Intermediate, down from $61.06 to start the year). This negatively affects revenues tied to gasoline sales or oil production.
- Increased interest rate volatility in US Treasuries.
- Very large outflows and inflows affecting the municipal bond market.
Unprecedented Fund Flows
In every sell-off, investors are tasked with distinguishing fundamental problems (basically cash-flow problems) from technical problems (basically, prices being dislocated due to supply and demand shocks).
- Fundamental problems tend to be longer-lived, affecting asset value for an extended period of time. Technical problems tend to be shorter-lived, but the timing of reversals is very unpredictable.
- Although the muni market is facing both problems, we attribute the majority of the recent negative performance to technical factors.
- On an average day, investors offer to sell about $750 million in par value in the secondary market. On Thursday this week, that number spiked to $4.2 billion. That is 5.5x higher than average and equivalent to a roughly 15-standard deviation spike in selling.
- That selling pressure was driven by a massive record-outflows from municipal bond funds. In the third consecutive week of outflows, municipal bond funds reported $12.2 billion of outflows for the week ended Wednesday, March 18. The previous record for outflows was around $5 billion back in 2013 around the Taper Tantrum. For context, in 2019, municipal bond funds had 51 weeks of inflows and only one week of outflows.
Municipal Bond Underperformance
These flows caused volatility and underperformance from municipal bonds in March.
Even the shortest-duration, most conservative municipal bonds were not spared. That is disappointing, as we rely on this portion of client portfolios for stability during equity market volatility.
- Take, for example, pre-refunded or escrowed municipal bonds.
- These bonds are usually backed by government securities in an escrow account. They typically have no additional credit risk when compared with owning treasuries.
- They also carry the typical income tax advantages from owning municipal bonds.
- Nevertheless, these bonds have underperformed treasuries by over 2% so far this month. This performance difference must necessarily reverse over time.
Opportunities for Client Portfolios and Credit Outlook
Where appropriate, we have been active during this period of volatility in adding client exposure to high-quality tax-exempt securities. In particular, we have found securities primarily backed by property taxes and by essential service revenues, like water and sewer fees, to be attractive options for client portfolios.
However, we do expect issuer creditworthiness to deteriorate across the market. That deterioration, however, will vary widely depending on the type of issuer. The accompanying table summarizes our views about the likely credit impacts of the COVID-19 and oil price disruptions, and our outlook for major sectors of the municipal bond market.
| Sector | % of Index | Credit Impact | Outlook |
| Pre-Refunded & Escrowed | 12.7% | None | Favorable |
| Local General Obligation | 11.6% | Low | Mixed |
| State General Obligation | 22.8% | Moderate | Mixed |
| Revenue – Tax | 12.2% | Moderate | Mixed |
| Revenue – Transportation | 7.3% | High | Unfavorable |
| Revenue – Leasing & Appropriations | 6.3% | Moderate | Mixed |
| Revenue – Water & Sewer | 3.7% | Minimal | Favorable |
| Revenue – Toll & Turnpike | 3.7% | High | Unfavorable |
| Revenue – Utilities – Other | 3.4% | Low | Mixed |
| Revenue – Education | 3.0% | Low | Unfavorable |
| Revenue – Power | 3.0% | Low | Favorable |
| Revenue – Airport | 2.9% | High | Unfavorable |
| Revenue – Industrial Development | 1.6% | Moderate | Mixed |
| Revenue – Health | 1.5% | High | Unfavorable |
| Revenue – Hospitals | 1.1% | High | Unfavorable |
Municipal Bond Market Conclusion
In seeking to maximize after-tax returns for clients, we have responded to municipal bond underperformance in March by adding to client holdings where appropriate. As long-term investors, the after-tax yield advantage of high quality municipal bonds appears attractive relative to some other fixed income options. We are mindful, however, that markets can stay volatile over the short-term. Over the intermediate-term, the main risks are credit-related as municipal entities respond to this period of restricted travel and social distancing and the corresponding reductions in tax revenues. The impacts will vary widely by sector and we will be active in positioning portfolios appropriately. If you have any questions, please contact a member of your client centric team.
Corporate Bonds – COVID-19 & Oil Price Shocks Elicit Heavy Outflows and Policy Responses
The best thing that can happen when you own a corporate bond is… nothing. Investment grade corporate bonds are generally considered lower-risk investments. They are used in client portfolios to generate incremental income over government securities. Typically, when you lend to a highly creditworthy corporation, you can expect a modest amount of extra income. You are planning to simply clip your coupons and receive timely payment of principal at maturity. You hope that nothing happens to upset that plan. Unfortunately, in March, a lot has happened. Fortunately, we entered this selloff in a relatively defensive credit position in most client portfolios.
Corporate Bond Spreads Reach Lehman-Episode Levels
Corporations across every rating category are facing significant operating stress due to COVID-19 containment measures that will cause a global recession in 2020, an oil price shock that sent prices down to levels not seen since 2001, and much tighter financing conditions than have existed at any point since the Financial Crisis. Investors reacted by selling an unprecedented amount of investment grade corporate bond in mid-March. By month-end the market recovered somewhat as investors digested accommodative policy responses from the Federal Government and Federal Reserve. In total, investment grade corporate bonds, even the most conservative, highest-rated options, saw negative performance in March.
| Maturity Range | |||||
| Weight in Index | Rating | 1-3 Year | 3-5 Year | 5-7 Year | 7-10 Year |
| 8% | AA | -1.1% | -2.1% | -2.2% | -4.1% |
| 42% | A | -1.9% | -3.5% | -5.1% | -6.7% |
| 48% | BBB | -5.0% | -8.4% | -9.9% | -12.0% |
| Treasuries | 1.5% | 2.3% | 2.9% | 3.8% | |
Source: ICE bond indices
That selling pressure pushed short-to-intermediate maturity investment grade corporate bond spreads to levels similar to when Lehman Brothers defaulted in September, 2008.
While we expect downgrades and corporate defaults to rise materially in the forward 12 months, the prices of corporate bonds may already fully reflect those expectations. Investors who held their corporate bond exposure through the Lehman Brothers period participated in a price recovery as 1-10 year investment grade corporate bonds outperformed treasuries by 9% from September 2008 – September 2009.
Credit Stress and Corporate Bond Performance Varies by Industry
While broadly negative, performance in March varied significantly by industry. Industries most exposed to COVID-19 and oil price disruptions performed the worst. Companies in energy, leisure, air travel and automotive all underperformed. Companies in healthcare, telecommunications and tech outperformed, but were still broadly negative.
| Maturity Range | |||||
| Weight in Index |
Sector | 1-3 Year | 3-5 Year | 5-7 Year | 7-10 Year |
| 29% | Banking | -2.4% | -4.5% | -6.5% | -8.0% |
| 3% | Financial Services | -6.9% | -10.6% | -9.7% | -11.9% |
| 4% | Insurance | -3.0% | -6.1% | -7.0% | -10.0% |
| 3% | Automotive | -5.5% | -9.3% | -13.5% | -13.4% |
| 4% | Basic Industry | -4.4% | -7.7% | -8.5% | -11.6% |
| 5% | Capital Goods | -2.2% | -3.9% | -6.5% | -7.1% |
| 6% | Consumer Goods | -2.4% | -3.8% | -6.1% | -7.2% |
| 9% | Energy | -7.3% | -12.6% | -15.4% | -19.3% |
| 8% | Healthcare | -1.3% | -3.3% | -4.3% | -5.0% |
| 1% | Leisure | -11.9% | -13.0% | -16.4% | -22.3% |
| 2% | Media | -2.2% | -4.3% | -5.6% | -7.2% |
| 3% | Real Estate | -4.3% | -8.2% | -9.8% | -11.4% |
| 3% | Retail | -2.2% | -3.3% | -5.4% | -6.3% |
| 1% | Services | -3.3% | -6.2% | -6.1% | -9.7% |
| 8% | Tech & Electronic | -1.1% | -2.7% | -3.8% | -5.8% |
| 3% | Telecommunications | -2.4% | -4.0% | -4.8% | -5.7% |
| 2% | Transportation | -4.2% | -5.5% | -5.1% | -8.8% |
| 6% | Utilities | -2.7% | -4.9% | -6.0% | -7.8% |
| Treasuries | 1.5% | 2.3% | 2.9% | 3.8% | |
Source: ICE bond indices
This performance divergence creates opportunities for relative value trading in corporate bond portfolios. We are currently assessing our exposure to corporate issuers, with a particular focus on balance sheet strength to weather a 12–18 month disruption in cash flows. Where we find attractive opportunities, we will be active in repositioning portfolios.
Policy Response & Market Reaction
Noting the stress in corporate funding markets, policymakers stepped in to provide support:
- Federal Reserve Actions:
- On Monday March 23, the Fed announced two initiatives that will (i) allow the Fed to purchase bonds & make loans to investment-grade rated companies in the primary market, and (ii) allow the Fed to purchase investment-grade rated bonds and ETFs in the secondary market.
- Federal Government Actions:
- The White House & Congress agreed on a $2 trillion stimulus package which was passed by the Senate on March 26.
- The bill includes a range of Federal support, including:
- Direct payments of $1,200 per adult and $500 per child, phased out for couples making above $150,000.
- More than $500 billion in support for businesses:
- Grants, loans and loan guaranties for specific industries, including $29 billion for direct lending to passenger and air cargo carriers,
- An expansion of the Small Business Administration loan program, and
- Support for the Federal Reserve’s programs.
- $250 billion Expansion of Unemployment Compensation
- Expands the period of unemployment eligibility to 39 weeks,
- Supplements weekly state unemployment benefits with a Federally-funded $600 per week payment for up to 4 months, and
- Includes many independent contractors and gig workers.
- In Michigan, this brings the maximum weekly unemployment benefit from $362 per week to $962 per week, or about $3,850 per month.
- Support for state and local governments and hospital systems.
The market has responded favorably to these actions. Corporate credit spreads fell roughly 1% in the last week of trading in March. Importantly, the primary market for corporate debt issuance opened up. Many deals were “oversubscribed,” meaning there was greater investor demand than the amount of bonds being issued. Issuers included many blue-chip companies, including:
- Oracle Corp (A3/A+) – $20 billion on 3/30
- Intel Corp (A1/A+) – $8 billion on 3/23
- Walt Disney Company (A2/A) – $7.25 billion on 3/21
- Nike Inc (A1/AA-) – $6 billion on 3/25
- Coca-Cola Co (A1/A+) – $5 billion on 3/23
- Home Depot (A2/A) – $5 billion on 3/28
If credit markets continue to thaw, we expect the vast majority of issuers to have the liquidity needed to weather the 12-18 month anticipated disruption from COVID-19.
Corporate Bond Market Conclusion.
We expect significant downgrades and defaults in corporate bonds over the forward 12-month period. Impacts will vary widely, and will be most severe in oil, leisure and travel-related industries. However, bond prices have already adjusted to Lehman Brothers-type levels. We will continue to assess the market environment, but for investors without significant near-term liquidity needs, corporate bonds can play an important role in portfolios now and into the future. If you have any questions, please contact a member of your client centric team.