Why munis now?

Amid tumbling bond yields, municipal yields have increased causing valuations, as measured by the ratio of the AAA muni yield to comparable maturity Treasuries, to be off the charts.

Typically, yields on munis range from 70-100% of that of Treasuries of comparable maturity, reflecting the tax advantage they provide, with lower yield ratios for shorter maturity bonds. But in the last week, the severe market volatility due to the coronavirus has shifted that significantly upward. AAA Municipal-Treasury ratios have spiked along the curve: 188% for 5-year bonds, 191% for a 10-year and 165% on a 30-year as of March 12, compared to 61%, 74% and 89%, respectively, on Feb. 19. This means that a AAA muni bond is yielding more than a Treasury even before factoring in the break on tax-free income.

At the heart of this development is that investors who typically consider munis a haven for risk-off are not pursuing them, as many are seeking not only safety, but liquidity via Treasuries.

Sectors that appear to offer good potential value include high-quality (AA/AAA-rated) state general obligation, higher education and water & sewer bonds. Conversely, one should be cautious with the likes of airports, ports, hotels and other areas likely affected by a drop-off in activity due to the virus.

But even potentially problematic sectors could be strong additions to a portfolio if the downturn slips into a contraction as munis traditionally have lower default rates than corporate debt and good track record weathering recessions. Even in an economic downturn, people still pay taxes, utility bills and the like, and historically, revenue sectors such as power companies don’t experience the same decline in earnings as a similarly rated corporate bonds.

Calling the perfect entry point in dislocated markets can be difficult. But traditional metrics suggest high-quality munis may merit a look.