Finding Opportunities Amid Muni Credit Crunch
Portfolio managers Kathy Krieg and Ozan Volkan discuss recent bond-market volatility, Fed liquidity fixes and how OIA is uncovering attractive investing ideas in the face of a recession that could last until the end of 2020.
The municipal bond market experienced modest interest-rate increases last week as investors gave back some of the previous week’s historic gains. Interest rates rose modestly as investors came to the realization that the economic effects of Covid-19 may be more severe and last longer than they had hoped. Credit rating agencies and investors alike are losing conviction in the possibility of a V-shaped recovery. Market liquidity, as viewed through the lens of bid-offer spreads, has improved dramatically from the historically wide levels seen in mid-March
Overall liquidity continues to be slightly less than 2019 levels and dependent on mutual fund flows. The good news is that after severe outflows on March 31, flows appear to have stabilized with slightly positive numbers in early April. We expect the “two steps forward, one step back” market behavior to continue as long as the uncertainty of the pandemic dominates the headlines. The muni market appears to be transitioning from Phase I, the Federal Reserve stepping up as a liquidity backstop, to Phase II, assessing the economic consequences of a complete global shutdown.
The big question for investors is how—and when—do we transition to a post-pandemic world and what will that environment look like? Against this backdrop, here are our answers to some of the questions we have been getting from investors and financial advisors:
Investor and Financial Advisor Questions:
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Why did interest rates on high-quality munis fluctuate so dramatically over the last few weeks?
There was a lack of market liquidity, which is an imbalance of buyers and sellers. The bond markets (both taxable and tax-exempt) are structurally different in 2020 compared to 2008 and earlier. Regulation has since limited the number of capital market dealers and these dealers are left holding fewer positions in inventory than they did in the past. As a consequence, we have observed that the selling of bonds among mutual funds and other bond investors has been met with weak or no bids, regardless of the credit quality of the paper. Historically, when these muni dislocations occur, institutional buyers like banks and insurance companies step in and buy the excess paper.
Since the 2016 tax cuts, these players have had fewer incentives to buy tax-free debt as tax rates were lowered to 21% from 35%. As a result, any imbalances between buyers and sellers can lead to large daily swings in interest rates. Fortunately, the Fed has agreed to step in as a buyer of last resort of investment-grade municipal debt. We believe the Fed’s intervention should eliminate the dearth of liquidity and help the markets become more efficient.
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How pervasive are credit quality issues due to a potential prolonged recession?
At Oppenheimer Investment Advisers, we’re monitoring the portfolios under the assumption that the economic slowdown will last for a long time—possibly until late 2020. State and local governments have taken the lead in fighting this pandemic but are bearing significant financial stress in the near term. Many municipalities have cash reserves and rainy-day funds they can tap, but revenue streams from personal income taxes and sales taxes have been disrupted. We expect deficits to be the common theme over the next few months. The federal government is already discussing another bailout program geared toward providing aid to state and local governments. We’re hopeful that sufficient support is on the way. We expect that some of the credits in our portfolios will see rating agency downgrades as a result of revenue shortfalls. However, we believe that these entities are resilient enough to withstand a prolonged downturn.
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Where do you see attractive opportunities in this environment?
For clients who need periodic income, there are significant opportunities to invest in high-quality credits at attractive long-term tax-advantaged yields. The key is to tactically and judiciously invest when these price dislocations occur. We have targeted specific interest rate levels in the market, depending on where we feel comfortable across maturities investing in high-quality credits. Our focus is on select state general obligation bonds, those first in line for federal aid, essential services and utilities.
The next few weeks—and possibly months—will be difficult for many people. As residents of New York City, we have seen firsthand how devastating this virus can be for communities. In the end, we expect that all communities will be economically impacted. But we are investing with the expectation that our credits and communities will come through stronger, more resilient and well-positioned to benefit from the recovery that we believe is on the other side.
For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Advisor.
Tax-exempt municipal bonds are issued by state and local governments as well as other governmental entities to fund projects such as building highways, hospitals, schools, and sewer systems. Interest on these bonds is generally exempt from federal taxation and may also be free of state and local taxes for investors residing in the state and/or locality where the bonds were issued. However, bonds may be subject to federal alternative minimum tax (AMT), and profits and losses on bonds may be subject to capital gains tax treatment. Municipal securities may lose their tax-exempt status if certain legal requirements are not met, or if tax laws change. The financial condition of the issuer may change over time and it is important to monitor the changes because they may affect the ability of the issuer to meet its financial obligations.
The MSRB's EMMA website (www.emma.msrb.org) allows investors to sign up to receive alerts about the availability of important information that may affect their municipal bonds. The MSRB makes official statements and continuing disclosures submitted to it by issuers and others available to the public for free through its EMMA website. EMMA also provides municipal securities trade price information through its Real-time Transaction Reporting System ("RTRS") and free public access to certain municipal credit ratings. See more at: http://www.finra.org/investors/alerts/municipal-bonds_important-considerations-individual-investors#sthash.snkM0mxf.dpuf
Special Risks of Fixed Income Securities: There is a risk that the price of these securities will go down as interest rates rise. Another risk of fixed income securities is credit risk, which is the risk that an issuer of a bond will not be able to make principal and interest payments on time. Liquidity risk refers to the risk that investors won’t find an active market for a bond, potentially preventing them from buying or selling when they want and obtaining a certain price for the bond. Many investors buy bonds to hold them rather than to trade them, so the market for a particular bond or a small position in a bond may not be especially liquid and quoted prices for the same bond may differ.
High yield fixed income securities are considered to be speculative and involve a substantial risk of default. Adverse changes in economic conditions or developments regarding the issuer are more likely to cause price volatility for issuers of high yield debt than would be the case for issuers of higher grade debt securities. In addition, the market for high yield debt may be less attractive than that of higher-grade debt securities.
© 2020 Oppenheimer Asset Management Inc. This commentary is intended for informational purposes only. The information and statistical data contained herein have been obtained from sources we believe to be reliable. Oppenheimer Investment Advisers (OIA) is a division of Oppenheimer Asset Management Inc. The opinions expressed are those of Oppenheimer Asset Management Inc. (“OAM”) and its affiliates and are subject to change without notice. No part of this presentation may be reproduced in any manner without the written permission of OAM or any of its affiliates. Any securities discussed should not be construed as a recommendation to buy or sell and there is no guarantee that these securities will be held for a client’s account nor should it be assumed that they were or will be profitable.
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