Muni Credit Tolerance To Be Tested For Sure

The decidedly strong price advances made thus far in May have left us scratching our heads, wondering if appropriate levels of risk are being factored in. Our skepticism does not come from a lack of confidence in the muni market, but rather from expectations that credit headwinds will prevail into the foreseeable future. As tax collections begin to flow back into state and local operating funds with greater regularity, and as revenue streams come back on line for enterprise issuers, the recovery will likely be slow with a still elevated level of unknowns. We can expect the credit headlines to intensify, and we are likely to see some otherwise very secure credits and off-the-radar names make the news. Now is certainly not the time to relax credit standards, but realistically there should never be a time as municipal bond portfolios should be designed with resiliency and long-term investment objectives in mind. It would seem that we are returning to technical factors as the market driver with outsized demand being left unsatisfied by lighter weekly calendars and sparse secondary supply, as well as with seasonal reinvestment needs. We are betting that the rationale for the shift back is rooted in expectations of supportive Fed intervention and possibly a growing outlook for higher individual and corporate tax rates.

Overall, states are in a good position to avoid default, but we allow for possible downgrades on a limited scale. With very isolated exception, state ratings can be expected to remain comfortably within investment grade range. the greatest potential for spread widening is likely to be found in pockets of the muni high yield market and this is where we can expect to see elevated instances of covenant violations and technical defaults, and even a higher probability of monetary default as liquidity and operational pressure become more pronounced. Much of the investment grade space can be expected to demonstrate resiliency, yet a downward notching in ratings may very well be more active than would otherwise be the case absent the COVID-19 pandemic.

We believe that it is appropriate at this time to question whether or not the unprecedented interventionist measures taken by the Fed and evidence of effective market functionality have created distortions in muni performance. Again, we are constructive on the asset class, yet we remain unsure of continued market momentum. We also recognize the role that ratios are playing in the formation of market sentiment, given the availability of historically cheap levels. As we see it, confidence is lending support to the muni market, but we must be mindful of potential sticker shock, even against a backdrop of historically cheap ratios offering compelling relative value that extends to corporate bonds.

Many issuers are exposed to the uncertainties surrounding the economic suspension with so many shifting to crisis mode as they are trying to revise revenue forecasts while holding the line on their fixed costs. Current yield levels continue to provide fertile ground for market entry, but for a large part of the issuer community, there are overriding concerns tied to credit, liquidity and specific capital plans. Given such conditions, seasonal reinvestment demand may not encounter sufficient supply and so technicals may outweigh credit considerations as the market driver for a while longer.

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