The Case for High-Quality Munis

Key Takeaways

• We have seen a historic level of fiscal and monetary stimulus, which supports essential credits in the high-quality municipal bond market.
• Pre-Covid-19, the country was in the midst of the longest economic expansion in modern history, which allowed municipalities to build substantial reserves.
• We expect some credits in our portfolios to see ratings downgrades as a result of revenue shortfalls but we think they’re resilient enough to withstand a prolonged downturn.
• Our focus is on select state general obligation bonds, those first in line for federal aid, essential services and utilities.

The second quarter of 2020 was one of the strongest periods for high-quality municipal bonds in recent memory. Interest rates across the maturity spectrum were 0.50% to 0.80% lower than pre-Covid-19 levels of Jan. 1. The drop in interest rates has been especially dramatic in short-term, high-quality paper where yield levels fell to a historically low level. Indeed, the yield on two-year high-quality paper was approximately 0.27%. This is a dramatic turnaround from mid-March when the yield stood at 2%.

Since the onset of the Covid-19 crisis, states and local municipalities have been thrust to the forefront of the fight against the pandemic, causing them to face significant challenges. The financial fallout has been palpable as rising health-care costs associated with fighting the disease and lost revenue from an unprecedented economic shutdown have roiled states. While these challenges seem enormous, we have also seen a historic level of fiscal and monetary stimulus, which supports essential credits in the high-quality municipal bond market. In our view, that has positioned investment-grade munis as a source of safety and security for investors in investment-grade bonds.

A thorough examination of these federal stimulus programs and a review of municipal finances prior to the outbreak suggest that investment-grade issuers remain attractive. Despite facing unprecedented fiscal challenges, many issuers continue to be a safe harbor in the face of uncertainty.

As conservative, tax-exempt core bond managers, we focus on investing in the high-quality AA general obligation and essential service sectors of the market. While some of these entities have been hit the hardest by the pandemic, many credits entered this crisis with some of the strongest balance sheets in decades. Pre-Covid-19, the country was in the midst of the longest economic expansion in modern history, which allowed municipalities to build substantial reserves. As recently as March 18, the Pew Institute stated that after the close of fiscal 2019, “states collectively have amassed the largest fiscal cushion in at least the last two decades.” Over the past decade, many municipalities built up fund balances and reduced debt levels, which created a buffer to support bondholders.

Many of these same municipalities have significant flexibility through inter-fund borrowing to tap various pockets of money earmarked for non-essential projects. Those cash stockpiles offset lost revenue. We expect to see any remaining deficits wiped out by spending cuts, tax hikes, and, in some cases, additional borrowing.

To date, municipalities have received significant federal support from the Cares Act, a $3 trillion program enacted to assist those entities most severely impacted. Along with state governments, health-care facilities, transit systems and the airline industry have received financial assistance. Under the Cares Act, a $150 billion coronavirus relief fund was established as a way to reimburse localities for Covid-19 related expenses. Additional support provided increased funding to new and existing municipal grants, many of which support local education, health care and food assistance programs.

In addition, the Cares Act created a new special purpose vehicle called the Municipal Liquidity Facility. The facility allows for the Federal Reserve to ensure market liquidity by having the ability to purchase up to $500 million in short-term securities from states, large cities, counties and designated essential services providers. In essence, the Fed has become the lender of last resort to municipalities. As a lender of last resort, the Fed is there to support issuers that believe the public market is not offering favorable borrowing conditions. To date, Illinois is the only state that has tapped the facility. Fed Chairman Jerome Powell has subsequently stated that the Fed has untapped resources to support municipalities in the event further assistance is needed. Fiscally healthy cities and states are critical to driving an overall economic recovery.

We have not ruled out the potential for additional fiscal support if economic conditions worsen due to a resurgence of the virus. Political rancor aside, we believe the likelihood of additional aid increases as the effects of Covid-19 become more widespread. Additionally, dramatic cuts to services and potential layoffs leading to increased unemployment will negatively impact U.S. GDP growth. The size of any aid package could be significant as the National Governors Association has requested $1 trillion.

We believe that the relative strength of the high-quality municipal bond market and the potential for higher future tax rates, current valuations offer compelling value for risk-averse investors. We expect some credit rating downgrades with the number dependent on the length and severity of the economic downturn. Still, we believe future downgrades have been priced into the market. We have already seen downgrades in transit and tourism, but given the high starting point of credit ratings, we’re confident these downgrades are manageable.

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