After a rough couple of weeks at the beginning of the economic shutdown caused by the COVID-19 pandemic, the municipal bond market has stabilized, but assessing credit quality is now more important than ever when deciding where to invest.
In a statement accompanying an April 30 report on the first quarter, the Municipal Securities Rulemaking Board said trading statistics “reflect significant disruption in the municipal securities market during late March and early April. Trading volume reached highs not seen since 2008, with par amount traded totaling about $1 trillion.”
That volume is compared to $756.2 billion reached in the first quarter of 2019. Retail trade activity (trades of $100,000 or less) declined, while institutional trading increased.
“It’s like nothing I’ve ever seen,” Ron Bernardi, chief executive of Bernardi Securities, a municipal bond specialty firm, said of the initial panic selling.
In response, the Federal Reserve in early April established the Municipal Liquidity Facility that offers $500 billion in lending to states and municipalities as part of a $2.3 trillion economic support package. The CARES Act, which was signed into law in March, provided $35 billion in credit protection for the facility.
Later in April, the Fed expanded the facility to cover counties with populations of more than 500,000 and cities that are 250,000 and bigger.
“In aggregate, the financial response has been larger than during the financial crisis,” said Dave Hammer, head of municipal bond portfolio management at Pimco.
The Fed intervention seems to have stabilized the municipal market. It’s not that localities have necessarily taken advantage of the lending opportunity, but knowing it’s there calms the waters.
“Over the last couple weeks, we’ve seen the market almost come back to normal,” said Tom Kozlik, head of municipal strategy and credit at Hilltop Securities.
Credit assessment becomes imperative
But normal is relative during the coronavirus. State and local governments are providing the lion’s share of services during the outbreak, which strains revenue and budgets. It is now more important than ever investors carefully navigate muni offerings.
“Digging deep into the individual credit is required,” Kozlik said.
Bernardi’s formula involves assessing the underlying credit quality of the deal, its intended purpose (e.g., funding bridge, road, school or airport construction or supporting public works upgrades) and whether the structure of the deal offers sufficient reserves or a reliable tax revenue stream.
He’s still bullish on muni investments.
“There are thousands of solid, quality issuers across the country,” Bernardi said. “The muni market in our economy, at the national level, will do just fine.”
The general market uncertainty will benefit state and local governments with strong reserves and good management.
“It’s going to accentuate the good credits,” Kozlik said. “This is the environment that pays off for them.”
There’s little worry about defaults in the investment-grade municipal sector, given the Fed support, Hammer said. The default risk is now greater for municipal bonds that aren’t backed by sufficient financial resources.
“We remain cautious on lower-quality munis in the near term, but we expect it will become an opportunity as many of these securities reprice,” Hammer said.
Partisan tension rises over fiscal support
While the municipal market finds its way, partisan tension surrounds federal efforts to provide more fiscal relief.
The CARES Act contained some funding for state and local governments. Democratic lawmakers want to make support for the sector a centerpiece of the next coronavirus stimulus package. Capitol Hill Republicans, led by Senate Majority Leader Mitch McConnell, R-Ky., are resisting making big expenditures for states that are suffering from non-virus-related issues, such as significantly underfunded pension plans.
Many states, however, need support for their coronavirus spending, Bernardi said.
“Congress needs to act,” Bernardi said. “The way to help municipal issuers is for Congress to grant money to help them recover from economic distress caused by the COVID-related shutdown.”
Kozlik has been warning of political risk in the muni market, which doesn’t look as if it will abate in the near future.
“To me, the priority is that state and local governments get some type of support that will allow them to continue to provide services because they are on the frontline of this health care crisis,” Kozlik said.