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Municipal bonds: Where we've been and where we may be headed

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Jon Rocafort, CFAManaging Director, SMA Portfolio Management, Parametric

      New York - Following a record sell-off and snapback, municipal bond investors may be wondering whether a historic buying opportunity has come and gone. Though the asset class has staged a dramatic turnaround following a surge in yields, we believe bargains still exist. Yields remain well above the recent lows. Relative value is compelling.

      Additionally, unprecedented actions by the Federal Reserve and the $2 trillion coronavirus bill should support liquidity and address near-term fiscal challenges. Volatility may persist as muni mutual fund outflows continue and credit concerns linger, but we believe demand for municipals should remain strong as investors continue to find value in attractive tax-adjusted yields and downside protection amid potential future volatility.

      Let's review what has transpired over the past three weeks, where that leaves us today, and the opportunities we see in the wake of this historic move.

      Before the sell-off started

      Muni yields fell to all-time lows on March 9. This contributed to the speed and magnitude of the sell-off as retail demand faded at the start of the month.

      PPArocafortblog1web

      In 2019 the municipal bond market posted its highest annual return since 2014, with the ICE BofAML US Municipal Index up 7.74%. The cap on the state and local tax deduction for higher-income earners — implemented as part of the Tax Cuts and Jobs Act of 2017 — created a greater appreciation for munis as a tax-avoidance tool. The result was 52 consecutive weeks of muni mutual fund inflows totaling $93 billion and eclipsing the annual record set in 2009. This market strength continued into 2020, with an additional $23 billion flowing into muni mutual funds through the end of February. Strong demand — combined with falling Treasury yields — put the ICE BofAML US Municipal Index up 3.17%, year to date (YTD), through February 28. This combination also sent the 10-year AAA muni yield under 1% for the first time in history. On March 9 a 10-year national AAA muni had a yield of only 0.81% — an all-time low.

      Why did municipals sell off, and how significant was the move?

      As concerns over the coronavirus and its economic impact began to grow, muni mutual funds — particularly high-yield funds — began to see large redemptions over the second week of March. This ended a streak of 60 consecutive weeks of inflows. With retail investors balking at yields inside 1%, the first wave of forced selling was met with little support. Dealers were forced to back up their bids significantly as their balance sheets swelled and Treasury volatility made hedging a challenge.

      Falling prices only made matters worse. Redemptions picked up steam. According to Refinitiv Lipper, investors pulled $12.2 billion out of muni funds during the week of March 16, almost triple the previous record. With dealers full, the rout resulted in a liquidity crunch reminiscent of 2008. By March 20 the yield on a 10-year AAA muni increased to 207 basis points (bps), to 2.88%, since the lows on March 6. In addition, the ratio of a 10-year AAA muni to a 10-year US Treasury had set an all-time record, surpassing 300%. The ICE BofAML US Municipal Index had declined 11.66% over the two-week period from March 6 to March 20 as its yield spiked to a six-year high.

      PPArocafortblog2web

      How the coronavirus liquidity crunch compares with other historic sell-offs

      The coronavirus liquidity crunch proved to be a more dramatic move compared with other historic sell-offs, including the 2008 financial crisis, the 2010-2011 sell-off following Meredith Whitney's call for a surge in muni defaults, the 2013 taper tantrum, and the period following the 2016 presidential election. The magnitude of the yield move, the resulting performance drawdown, and the extent to which munis cheapened relative to Treasuries exceeded all those historic moves. Like the current sell-off, the weaker markets rattled nerves. They were also often viewed by muni market participants as an attractive entry point. As highlighted in our March 23 blog post, we believe a similarly attractive entry point has emerged.

      PPArocafortblog3web

      Why did the market turn around so quickly?

      Following the historic rout the week of March 16, the week of March 23 began with high-quality muni yields exceeding those of similar corporates for the first time in this cycle. Additionally, the muni-to-Treasury ratio was in excess of 300%. The stage was set for savvy investors to emerge and offer support for something too tempting to ignore: high-quality bonds at fire-sale prices.

      On March 23 the Fed announced unprecedented measures to shore up muni liquidity, including one to expand the existing Money Market Mutual Fund Liquidity Facility to include a wider range of securities, such as municipal variable-rate demand notes. In addition, the $2 trillion coronavirus bill was coming into focus, with at least $350 billion in aid, grants, loans, and funding for municipal sectors and entities. As a result of the bill, the market began to find support at yields of 3%-4% for high-quality AA names from direct SMA buyers and crossover buyers such as banks and insurance companies. An enormous amount of capital materialized in a short period of time, sending high-quality muni yields down 165 bps over the week and the ICE BofAML US Municipal Index up 8.67%. This was a staggering comeback from the liquidity-induced rout that plagued the market during the previous two weeks.

      PPArocafortblog4web

      Let's look at the yield changes over the sell-off, the historic turnaround, YTD, and where current yields are compared with the historic lows on March 9.

      PPArocafortblog5web

      Where are we today?

      While the rebound has removed the extremely oversold condition from the market, we think the current environment still offers favorable relative value when compared to Treasuries and corporates. Investors still have the opportunity to invest at attractive real rates of return, especially considering the disinflationary pressure of the pandemic. We also remain approximately 60 bps higher in yield compared to the lows on March 20.

      PPArocafortblog6web

      For those investors thinking they missed the opportunity, we remind them volatility is likely to continue. And we see value in the trading opportunities created by market volatility, as a number of factors may lead to higher yields and continued volatility in the near-term, including:

      • Continued muni mutual fund outflows
      • An uptick in new issue supply
      • The potential of less support from crossover buyers such as banks
      • Perceived heightened credit risk
      • Direct buyers and SMAs balking at lower yields given heightened credit risk

      Bottom line: Following a record sell-off and snapback, a historic buying opportunity has not necessarily come and gone. Yields remain well above the recent lows and relative value is attractive. Volatility is likely to continue and should provide investors with attractive entry points and relative value trading opportunities.