Brad here. Today we’ll get an update on the municipal bond market from Nick Follett, manager of fixed income on our Investment Management and Research team. Over to you, Nick.
Municipal bonds are often described as the “stay rich” rather than the “get rich” asset class. But what happens when economies shut down and tax receipts plummet? Or ridership in mass transit falls as more people work from home and stop riding the subway? Given these shifts—plus the noise coming out of Washington for more rounds of stimulus—what’s happening today in the municipal bond market?
Headwinds for the muni market?
There are two main types of municipal bonds: revenue bonds and general obligation bonds.
- Revenue bonds are backed by the income generated from using the project (e.g., toll roads, mass transportation, water and sewer projects).
- General obligation bonds are backed by the ability of the issuer to impose taxes (e.g., the Commonwealth of Massachusetts or the State of California).
If people aren’t driving, using subways, or going to restaurants and stores to incur the state sales taxes, there will be serious headwinds to the asset class. And if people stop spending money, there will be no sales and other taxes collected, which will ultimately hurt the financial condition of states. All of this is true.
But what’s also true is that many states have rainy day funds that they’ve just started to tap for these very reasons. They also have the ability to raise taxes. Finally, they can furlough or lay off employees. From a human perspective, this choice is sad and unfortunate. From a financial perspective, it’s the right thing to do, and states have started doing it. It’s difficult to say with any confidence how this situation will shake out. But we do know that there will be winners and losers.
Given that the muni market is so heterogeneous, one has to be clear about painting with too broad of a brush. Take mass transit, for example. The agency that runs the New York subway system is the second-largest issuer in the state, apart from the state itself. This system is poorly run, many hate it, it loses money every year, and no one is riding it right now. That said, it’s fundamentally critical to the city that it exists in the same way that New York City is critical to the U.S. economy. In fact, New York City represents 10 percent of the GDP of the country. Without the Metropolitan Transportation Authority (MTA), New York City doesn’t exist in the same capacity. In May, the MTA came to the market and had 3x more bids than bonds available for sale. It’s too big to fail in a way that a high-speed train from San Francisco to Los Angeles or light rail in Tucson, Arizona, isn’t.
A wave of defaults?
In general, we still have a positive outlook on most areas of the municipal bond market, with an emphasis on higher-quality bonds with an A or better credit rating. For reference, nearly 93 percent of the market for municipal bonds that are rated by Moody’s have an A or better credit rating.
Recently, the Wall Street Journal published an article titled “Muni Defaults Surge, but Yields Don’t Follow.” That’s some pretty scary stuff, but it’s important to put the numbers into perspective when talking about municipal bond defaults. Yes, it’s true that the number of defaults has increased this year. But they have largely been smaller, more speculative deals that account for a very small portion of the overall market by par value. When you actually look at the amount of money that has been affected over the first half of the year by municipal defaults, it accounts for only 0.0245 percent of the overall market. Even if we assume defaults rise at a similar pace for the rest of the year, an annual default rate of 0.049 percent is still well below the historical average long-term muni default rate of 0.15 percent.
For comparison’s sake, the global corporate bond default rate over the same time period is just over 10 percent. One of the major reasons these default rates differ so much is the composition of the two markets. The muni market’s median credit rating is Aa3, compared with the median corporate rating of Baa3. These figures come from the annual Moody’s default study and include 46 years of data. While the idea of a wave of municipal bond defaults makes for enticing headlines, the actual numbers don’t really back it up.
More pressure ahead?
As for performance comparisons, municipal bond performance has lagged compared with Treasuries or investment-grade corporates year-to-date. In large part, this lag is owing to the effect of the Fed, which has done much more to support those markets compared with munis. With that being said, munis are up more than 4 percent year-to-date, and we’ve started to see the ratios between municipal and Treasury bond yields start to come back closer to normal levels. Muni yields are also largely lower today than they were to start the year, highlighting investor confidence in the market despite the challenges created by the pandemic.
Ultimately, while we certainly expect to see continued pressure on certain areas of the muni market (especially smaller, more speculative offerings or revenue bonds that rely on sectors like higher education or tourism), we do not expect to see a large wave of defaults coming any time soon for the vast majority of the muni market. This is where active management comes in. There are such quirks with the muni space that it really requires deep analysis and decision-making.
New Jersey toll roads have a lockbox on the revenue that the state can’t access. So, while the New Jersey general obligation bonds are to be avoided, New Jersey toll roads are fine. Pennsylvania toll road revenue can be accessed by the state. So, while the Pennsylvania general obligation bonds are fine, Pennsylvania toll roads are to be avoided. Managers know this, but indices don’t care.
Look beyond the headlines
In a nutshell, munis are fine. If you look beyond the headlines, the numbers continue to be encouraging. The trick is to make sure you pick the winners and, just as important, avoid the losers.