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Weaker federal support for munis sparks stronger demand from crossover buyers

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      By Nisha Patel, CFADirector Fixed Income, Portfolio Management, Parametric

      New York - Certain segments of the financial markets and the US economy have benefited disproportionately from federal aid. Liquidity facilities announced in April for the corporate bond market have helped to buoy valuations and push prices higher.

      The Bloomberg Barclays US Corporate Bond Index bounced back with an impressive monthly return of 5.24% in April, leading all fixed income sectors. Equities unsurprisingly had a strong month as well, with the S&P 500® Index returning 12.68% in April.

      However, muni bonds enjoy less assistance from the Federal Reserve's Municipal Liquidity Facility (MLF), reflected in an April return of ‑1.26%, proxied by the Bloomberg Barclays Municipal Bond Index. While the scope of the MLF comes close to that of the Primary Market Corporate Credit Facility (PMCFF) for the corporate bond market, muni market investors have been skeptical of the MLF and the extent to which it'll help.

      A key difference between municipal and corporate credit facilities is that the corporate versions entail open-market bond purchases. Investors view this not just as support for issuers but also as support of market value. Corporate versus municipal market returns for April are a clear indicator of this difference in perception.

      The need to increase supply has put additional pressure on the muni market. Retail investors are wary of putting money to work amid growing credit concerns. Elevated supply, combined with the disparity in federal support, has caused muni yields to cheapen relative to corporate bonds. Simply stated, we believe municipals are very attractively valued. The table below highlights this relative attractiveness across the curve.

      On a tax-adjusted basis, 10-year AA-rated munis yield 36 basis points above 10-year AA-rated corporates — double the difference since the beginning of March.


      With the relative value of munis this compelling, we've seen a surge in interest from crossover buyers such as banks and insurance companies. We believe any further weakness in munis — on either the supply side or the demand side — will be met with crossover buyer interest. If absolute corporate yields stay at current levels, the emergence of capital from crossover buyers should provide support for munis in the near term.

      Bottom line: Yield dislocation created by uneven federal responses may present an opportunity for long-term muni investors with the help of professional credit oversight.