COVID-19's Impact on the Bond Market
Henry Dormitzer of Choate Investment Advisors continues the conversation on municipal bonds with Anson Clough and Nathan Harris of Appleton Partners as they discuss the current state of the bond market.
To listen to the first part of the discussion, “The Basic Concepts of Municipal Bonds,” please click here.
Henry Dormitzer: Alright, we are back to talk about municipal bonds some more. Last time we talked about the basics of municipal bonds. This time we are going to go further. I am Henry Dormitzer, and I am a senior portfolio manager with Choate Investment Advisors, and I am joined again today by Nate Harris and Anson Clough from Appleton Partners where they manage $9.5 billion of municipal bond portfolios. Last time we talked about the basics. I think a lot of investors have in their mind, “I think of my municipal bonds as my safe assets.” Some income and assets that aren’t really going to go down in value so much when stocks go down in value, but in March with the COVID crisis, the beginning of that, we saw municipal bonds go down -- I saw some go down 10 percentage points -- and that was a big deal and startled investors. So Anson, I want to turn to you first to talk about what the heck happened in March and then later we’ll go to you Nate to talk about whether we should be worried about municipal bonds generally. So Anson, what happened in March?
Anson Clough: March was an interesting time. Ultimately you had the coronavirus cause fear that led to market volatility in early March and throughout March. The grab for liquidity was led by investors’ desire for cash and safety. As the virus made its way on to the U.S. shores in mid- to late-February, concerns of an economic shutdown both domestically and globally led to a price equality trade on U.S. treasuries. Demand for the safety of U.S. treasuries that perceived highest credit quality there is caused a 10-year treasury to drop from a 1/60 percent range in mid-February to a low of 54 basis points on March 9. Meanwhile, investor-led fear and selling took the S&P 500 down almost 35% between late-February and March 23. And more germane to a loss in this conversation Henry, in the municipal bond market, it took until mid-March before we really saw the angst enter that market as municipal yields were dropping with treasuries until that March 9 time period. But then market perception changed from municipals as selling municipal bond mutual funds and ETFs began that week and over the next five weeks, municipal bond mutual funds had almost $47 billion in outflows and selling of ETFs caused the ETFs to drop close to 8 to 10% in that same time period. As mutual fund investors raised cash, the fund companies were forced to sell bonds into a market with limited buyers in order to raise the cash to meet the redemptions. In a scenario where funds have to raise cash with limited equity, they are forced to sell whatever they can. This tends to be their highest quality bonds. As the yield liquidity grew, prices were dropping causing yields to go higher and higher in order to attract buyers. In fact, the 10-year AAA municipal yield reached a low on March 9 of 78 basis points only to reach a near-term high two weeks later at 2.79%, over 2% grew higher in yield. Meanwhile, remember that during this time the treasury curve had strong demand from the flight to equality trade and yields remained low. This created an interesting phenomenon which highlighted relative attractiveness of municipals to treasuries. Since municipal yields increased and treasury yields remained below low 1%, the relationship between the two asset classes became a bit distorted with municipals becoming extremely cheap or attractive relative to treasuries as measured by the ratios of municipals to the treasury.
We discussed earlier the historic 10-year AAA muni has averaged 86%-87% percent of the 10-year treasuries since 1990 and started early March at 82% only to get over 300% of treasuries by March 20 at the peak in yields. That means municipal yields in 10 years were three times higher than treasuries where typically there are 87% of treasuries. Initially, it was a desire for cash that caused selling but growing credit concerns also triggered sales due to fears of a long economic slowdown and the resulting credit impact on municipalities like states, cities, and towns to various other entities like airports, toll roads, hospitals, among other credits. Eventually, the value represented by extremely cheap municipal offerings caused the outpost to stop and demand began working its way back into the market by mid-April.
Henry Dormitzer: Yeah, that’s fascinating Anson. So, an investor might say, “holy smokes, my muni’s didn’t quite act like I expected them to but then they started coming back after some amount of time.” I am going to come to Nate next but before we leave this talk of trading, does this mean that investors need to think differently about the role of municipal bonds in their portfolio or are they still a rule of safety in a portfolio?
Anson Clough: Municipals are a core part of a well thought-out asset allocation model for high network individuals because of their tax exemption, but also their strong creditworthiness which has been exhibited over time. Sure there have been limited times and disconnect like we saw in March but long-term holders of municipals understand the creditworthiness of these credits and the perpetual nature and role they play in our economies and they know to not underestimate their ability to work through these difficult times. For these reasons, investment companies understand the risks, but they also realize the opportunities presented when strong high-grade municipal names are trading at yield multiples of two to three times treasuries. In addition to professional municipal investors seeing the opportunity, non-traditional buyers or cross-over buyers, taxable buyers like funds and institutional accounts come into the municipal bond market looking for opportunities to buy bonds at levels not seen in a very long time relative to other investment asset classes. Eventually, the retail investors understood the value and that high-grade names would be able to work through the economic downturn and still be on solid ground. Thus, these high-grade names in the municipal universe started trading higher in price. The increased interest on demand for municipals ultimately led yields lower and we actually saw the 10-year ratio go down closer to 200% for much of April and May and today’s strong demand for municipals has brought yields down closer to 100%. So, even at these current levels and ratios around 100%, we are finding value in municipals especially when the Fed comes out and says they aren’t likely going to move the Fed fund rate off of zero until 2022.
Henry Dormitzer: That makes a lot of sense. It sounds like the municipal market acted like a market bear when a lot of people wanted to sell, values went down and yields went up, but that had the effect of drawing new people into the market, but then bid prices down to a more normal level. So, as long as we don’t suffer permanent impairment in these investments because of a core credit problem, the market acts normally, just don’t think as an investor you might be able to liquidate your bond any day you want or if you do, you might be taking a loss. So, we saw the market go bad, but it came back.
Anson Clough: That’s exactly it, Henry.
Henry Dormitzer: So, let’s then put trading to the side because we saw some real trading anomalies and then a normalization of trading and ask the question of Nate which is, “Is there a risk of permanent impairment in municipal bonds and should investors say I am a little worried about using these as safety in my portfolio?”
Nathan Harris: Thanks, Henry. And certainly COVID-19 has impacted all corners of the municipal market. During the mid-March flights equality, there was an immense amount of uncertainty or caution and that uncertainly was driven by how far or how deep was the virus going to spread, what were going to be the implications on people’s health, implications on the healthcare system and as state and local governments moved to curve the virus spread, there was uncertainty about what those regulations or strategies would do to the economy. We started seeing unemployment go up, we’ve seen businesses shutter and there was an immense amount of caution about what this impact would be on state and local governments. As we moved through April and more information became available, investors in the municipal market began to really look at past crises and how high-equality municipal issuers had fared during other down cycles. Well certainly the current events may be described as unprecedented, the track record of state and local governments managing through unforeseen events, managing through other periods which could have been described as unprecedented, is very strong. They have a number of tools at their disposal and essentially they are out there on the front lines providing essential services even during health care pandemics or economic disruptions. Moody’s puts out a default report annually on the municipal market. It’s a great resource and it goes back to 1970. If we look at the accumulative default rate in the municipal bond market from 1970 through 2019, it’s 0.16% of the municipal bonds outstanding for each given year. It is an extremely small number. Now this is not our forecast but say we put out an example of COVID-19 resulting in a multiple of five times that default rate because of the economic impact, that would still result in a default rate of 0.80% of the municipal market. So below 1% despite certainly a very serious health crisis and economic disruption. Now, given that track record, we have very high confidence that high-quality essential service providers within the municipal market will be able to weather through this downturn and will be instrumental in the eventual recovery. Segments that have been more immediately impacted in this bull market include toll roads, airports, and transportation-related issuers. We have government shutdowns and businesses closing. The amount of people using these infrastructure assets certainly experiences a deep decline at the end of March and into April. At Appleton Partners, where we have taken the approach is to dig deep into each one of these issuers and really look at what are the underlying fundamentals versus the reality. I think toll rolls is a good example. The perception is that as a transportation asset that everyone would stop driving, they would stay at home and in reality while traffic did decline and we saw an average traffic decline about 50%, troughing in the first month of April, that is starting to come back well before states and localities began re-opening. In some instances, traffic is down only 30% year over year. Now, that’s not a great number but the perception is that a toll road and traffic and transportation would be much weaker in the current environment. We also take a hard look at airports. Certainly flying is down dramatically and in some instances over 90% compared to the same period last year, and looking at the top 15 airports across the country, for us liquidity is paramount. If these airports experience no revenue over an extended period, what is the pain point? What is the ultimate outcome? I think surprisingly -- I don’t know if this is expressed widely enough is that -- airports generally carry a high amount of cash and investments on their balance sheet during normal times. We took a look at the top 15 airports as I mentioned before and on average those airports have enough liquidity to survive 20 months, meaning survival is paying normal operating expenses and paying their debt obligations. I think that is a little conservative because given the reduction in flights, certainly, these airports have the ability to reduce their operating expenses as well. There is some operating leverage there. So in reality that 20 months is more like 35 months or 30 months assuming no revenues. Again, they are receiving revenues now so again taking more of a conservative approach.
Henry Dormitzer: So that is really reassuring, the municipal cash reserves and their ability to manage and the core essentiality of the service, the fact that people get back out and drive even during the COVID crisis is an example of essentiality that this stuff gets used. That is reassuring when you ask the question about potential impairment. I am going to ask a question about how this compares to corporate credit. I am going to ask it in a leading way because I know in corporations they run out of money and they default. Often times all of their debts become due and payable all at once and if you were an individual where all your debts were due and payable all at once, it would be hard to pay it all off instantaneously. That is called acceleration. Generally, Nate, I think acceleration doesn’t exist in the municipal market so that type of risk -- the one that corporations face -- doesn’t exist for municipalities either.
Nathan Harris: Absolutely, Henry, and certainly that the lack of acceleration on debt is an important part of staying local. That structure and how they manage their debt. Another important point to make is municipalities typically amortize their debt. In other words, it’s like their mortgage. They are paying off principal year after year. Corporations while allowed to do that, typically will issue their bonds and the maturities will be concentrated in specific tranches or 10 years out is a common form of corporate debt and what is quite often as well, is they do not use their internal resources or revenues to pay that debt. At maturity, they usually will roll it into an additional issuance. On the municipal side, that is rarely done with the exception of fundings to lower costs but in general, municipalities have structured their debt much more conservatively than corporations. And Henry, you made an important point too that I would like to touch on too. I think essentiality is a big driver of municipal credit and creditworthiness through down cycles and economic downturns. These municipalities provide services even during times like these and are instrumental in the eventual recovery. I think that is why we see not only municipalities use a number of tools to remain financially viable but we have also seen the federal government step in immensely in the current situation understanding the importance of well-operated state and local governments. Some of those examples of where the Fed is supporting the municipal market was the CARES Act which was the first one that came out. I think that is important because it was $2 trillion in total aid to the market and it got done in only a couple of weeks. If we look back to the last financial crisis, the Americans Recovery and Reinvestment Act was the stimulus package that was passed by Congress in 2009 and that actually took six months after Lehman’s bankruptcy and it was $881 billion. So, just the swiftness and the size of the federal support has been very strong. At the state and local level, there was over $150 billion that has been handed out to state and locals as part of the CARES Act and that really was aimed at helping those municipalities combat the outbreak of the virus. Certainly, they are on the front lines as far as healthcare and ensuring that their population is safe. I think that Congress and the federal government realized that and appreciate that and that is why that first tranche of the first stimulus was so swift and so directive. We have also seen the federal government step in and provide support so that municipal markets on the trading side -- on the bond side -- although they have not been necessarily active in buying bonds, they have rolled out some programs that provided essential back stop and we have really seen that help in the recovery as far as pricing on municipal bonds. We do think another tranche of aid will be passed by Congress. The timing is a little uncertain right now but I do think that there has been bipartisan support in recognition that while the first CARES Act helped to provide liquidity on the healthcare side and the expense side, the delay in tax revenues and in some cases the decline in tax revenues, is presenting a liquidity challenge. The next round of stimulus will be more so to bridge the gap between now and then recovered a few months from now so that state and local governments can continue to provide services and continue to be viable financial entities.
Henry Dormitzer: This is very helpful Nate and Anson. What I take away from it is investors would be wise to anticipate trading anomalies. They happen but because these underlying securities -- the municipal bonds -- are fundamentally pretty strong, new investors come in and re-establish a normal trading market and because these services are essential, have cash and have more flexibility, generally speaking, this is a secure market that you can find good value in.
Thank you very much for spending the time with us today. It has been a real pleasure to talk to you Nate and a real pleasure Anson. Thank you.
Anson Clough: Thank you Henry and we really enjoyed this opportunity.
Nathan Harris: Yes, thank you, Henry.
The information provided in this recording is for informational purposes only. While Choate Investment Advisors makes every attempt to present accurate information, the information on this recording may not be appropriate for your specific circumstances and it may become outdated over time. The views expressed on this podcast are personal opinions only and should not be construed as financial advice for your given situation. Moreover, the views expressed by Appleton Partners are not necessarily endorsed by Choate Investment Advisors and Choate Investment Advisors may decide to select investments on a different basis at any time and without prior notice. Finally, as everyone should know, past performance is not a guarantee of future performance.