Munis still attractive but headwinds emerge
The municipal bond market is in a similar place to other fixed-income credit markets: after having rallied sharply from its March lows amid massive monetary and federal intervention, the focus now is on credit dynamics amid the likely choppy path of economic recovery.
Early in the second quarter, municipal bonds were trading at yields that were about 2 to 5 times higher than comparable-maturity Treasury securities, attracting strong demand from institutional and retail investors and feeding large flows into muni bond funds as the appetite for risk re-emerged. The rally slowed by quarter-end as Covid-19 cases started to spike again, reaching new highs in the South and West and forcing many states and regions to pause and roll back reopenings. The likely gradual and fitful recovery ahead will present both challenges and opportunities to municipal credits.
Despite Cares Act grants, likely additional “Phase Four” federal funding and healthy balances in many state rainy day funds to cushion the blows, large states and many local governments still face wide deficits as revenues from income and sales taxes have fallen sharply. Various revenue bonds sectors—including Airports, Toll Roads, Hospitals and Higher Education—have faced sharp revenue and cost challenges in this uncertain time. That said, the likely bottoming of the economy in May and loosening of various restrictive measures have begun to produce improvements that support various municipal sectors, from labor-market strengthening to returning hospital volumes for elective procedures.
Even after their spring rally, tax-exempt munis and taxable munis still look somewhat cheap relative to Treasuries on an historical basis. We remain cautiously constructive on their relative performance going forward based on valuation, the fiscal and monetary policy supports in place and the prospect of economic recovery, albeit clouded by the Covid-19 infection growth and the challenges that creates.