The Case for High-Quality Munis
- July 31, 2020
Tax-Exempt Fixed Income
Kathy Krieg, Senior Portfolio Manager
Ozan Volkan, Senior Portfolio Manager
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.
Balance Sheet Buffers
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.
A Rescue Care Package
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.
More Stimulus on the Way?
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.
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.
©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. Past performance does not guarantee future comparable results. Neither OAM nor its affiliates offer tax advice .Investors should consult their own tax advisors and counsel. OAM is a wholly owned subsidiary of Oppenheimer Holdings Inc. which also wholly owns Oppenheimer & Co. Inc. (“Oppenheimer”), a registered broker/dealer and investment adviser. Securities are offered through Oppenheimer and will not be insured by the FDIC or other similar deposit insurance, will not be deposits or other obligations of Oppenheimer or guaranteed by any bank or other financial institution, will not be endorsed or guaranteed by Oppenheimer and will be subject to investment risks, including the possible loss of principal invested. This material is not a recommendation as defined in Regulation Best Interest adopted by the Securities and Exchange Commission. It is provided to you after you have received Form CRS, Regulation Best Interest disclosure and other materials. 3165219.1