Flight-To-Quality Sends Muni Yields Down To Record Lows

We are open to the idea of lower yields even if the Fed holds rates steady, and at this point we cannot completely dismiss the notion of zero or even negative Treasury yields for parts of the curve, although we still do not assign a high probability to this scenario. If greater macroeconomic concern takes hold, we can expect more flattening to the Treasury and other global yield curves. The rally in the muni market has taken long-dated MMD AAA benchmark yields down by nearly 50 basis points since the beginning of the year. The out-sized demand for U.S. sovereign debt can explain the year-to-date under-performance of Munis versus Treasuries throughout the coronavirus-driven bond market rally. We suspect that when sentiment shifts, Munis are poised to outperform the sell-off.

Munis have been booking solid gains even without the quality trade, driven by the inability of market supply to keep pace with out-sized demand for product, and a particularly unique set of circumstances that have elevated the issuance and investor appeal of taxable municipal bonds. Any sustained disruption in the pace and/or direction of muni fund flows could ignite a market correction of material magnitude given the currently low base level of yields. For now, we see continued demand as a primary driver of performance, and whether or not the Fed eases policy, muni yields are likely to stay at or within range of these historically low levels. Throughout the near-term, we are likely to continue the risk-on/risk-off cycle, which could introduce some interesting buying opportunities.

As long as rates stay low with the right curve bias and spread relationships, we do not expect the taxable muni build to dissipate any time soon as issuers work within the constraints of the Tax Cuts and Jobs Act, and seek to advance refund outstanding tax-exempt bonds. While taxable munis broaden the investor base and offer credit diversification and quality attributes to foreign and cross-over buyers, U.S. taxpayers seeking tax efficiency continue to derive benefit from conventional tax-exemption. When we use the quality argument, we can cite the lower default and higher recovery rates that have consistently punctuated the allure of the municipal bond market.

Munis are not tied to earnings releases and a host of other shorter term influences that typically impact corporate and equity security valuations. Such favorable characteristics can help offset the more pronounced liquidity risk inherent with the muni asset class, although liquidity for corporate buyers becomes less of a focus as they reach for yield in a declining rate environment. We would even suggest that as spread compression between corporate bonds and taxable munis continues to take hold, with corporate bonds offering better value, the quality and diversification traits of munis may be the ultimate investment determinants.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Advisor.