Years from now, it’s possible we could look back on early March 2020 and say, “That was a moment when we nearly saw fixed-income markets unravel.” One key signal of the market’s threadbare condition may’ve appeared during the week of March 9, 2020, when the current yield of municipals over U.S. Treasury bonds—the 10-year MOB spread, a measure of muni bond value and the overall attractiveness of muni tax advantages—spiked above 209%¹, surpassing levels last seen in the darkest days of the Great Financial Crisis (GFC).
Between March 9 and March 20, muni bond total returns had fallen from 3.7% to -7.5% year to date—a precipitous decline by any historical measure for the asset class.² Fears of rising default risk across the transportation, energy, and travel and leisure sectors—as well as state and municipalities’ general obligation (GO) bonds—cascaded through the market, pushing many investors out of tax-advantaged positions into cash.
Stimulus may've saved us
When fixed-income market liquidity is drying up, as it has in recent weeks and in past crises like the GFC, broker-dealers suddenly start acting as agents only, foregoing acting as principals trading for their own accounts. These insider expressions of profound concern over the credit cycle quickly became general in the market earlier this month, as the coronavirus pandemic upended normal market dynamics with its sudden threat of black swan economic impact.
Luckily, however, uncertainties over government action began to clear as the Fed injected literally trillions of dollars of liquidity into the market and, by Sunday, March 15, had put forth more historic stimulus measures. These have now been followed by an equally historic fiscal stimulus package from the U.S. government that includes provisions for airlines, healthcare, state and local governments, and small business.
Short-term challenges for transportation revenue bonds
While government stimulus should be a net benefit for many segments of the muni bond market, it doesn’t change our fundamental view.
As investors, we believe that transportation sectors will have a difficult time weathering this crisis, but we believe that with the backstop of major stimulus and monetary accommodation, they’ll weather it. Travel bans will drive down traffic at U.S. airports, negatively affecting literally every revenue stream available from this segment of the market. However, airports with higher cash reserves and lower operating costs will be more likely to withstand this decline in demand. Furthermore, airports that can delay large capital improvement plans will be able to respond dynamically, while airports that serve fewer international passengers may experience a more modest decline in revenues relative to large international hubs.
Airlines will face similar obstacles. Many airlines issue tax-exempt debt to fund maintenance facilities at airports and to fund new terminals or rebuild existing ones. Terminal projects are more integral to airline operations than maintenance facilities and should be less likely to come under scrutiny as airlines must navigate this new landscape.
"While government stimulus should be a net benefit for many segments of the muni bond market, it doesn’t change our fundamental view."
Lower energy prices may eventually boost toll road operators
Toll roads are also likely to face some short-term pain. With fewer people going to work and more areas on lockdown, there are simply fewer people on the road. Additionally, a drop in economic activity will result in fewer commercial vehicles using toll roads, putting further pressure on revenues.
Importantly, the news for toll roads isn’t all bad. With the price of oil down significantly, lower fuel prices—and even lingering fear over subsequent waves of COVID-19—should spur Americans to drive more once restrictions and limitations start to lift. In addition, we think toll roads with greater cash reserves should have an easier time managing the temporary lower traffic levels.
General obligation bonds—a more challenged market segment
As active managers, we’ve been deemphasizing GOs for some time, as their fundamentals appeared weak to us in the late-cycle economic environment over much of the last two years. Many municipalities rely on sales tax and income-tax revenues, which are highly cyclical with the economy.
But on top of this economic exposure, GO issuers are also faced with the added burden of managing and funding their pension systems. Asset price declines and lower bond yields for pension funds across the country are likely to result in increased pension-related costs for many states and municipalities.
Latent opportunities among select GOs
In the context of the current health and economic crisis, sales tax revenues may increase as consumers stock up on goods today but are likely to be below average in the coming weeks or months. Sales tax bonds with higher debt service coverage ratios will fare better than ones with more narrow coverage.
We also think that state and local governments that have built rainy day funds and other reserves during the expansion should be better positioned to ride out this downturn, and local governments that rely more heavily on property taxes should have more stability in their budgets.
Healthcare muni bonds: a Darwinian situation
Hospitals and other healthcare-related segments are facing tremendous challenges as the country tries to overcome the spread of COVID-19. While fiscal stimulus will undoubtedly help, we see management team strength as the key to issuer resiliency across the sector: Those systems and facilities with experienced and prepared leadership are likely, in our view, to limit the financial risk exposure dramatically.
Over the short term, the entire healthcare muni sector will be stressed as costs rise, resources are strained, and revenues decline. Many higher priced procedures and elective surgeries are likely to need to be rescheduled due to the redeployment of staffing and space to treat those who have contracted COVID-19. While we project the entire system will be under pressure, over the long term we see adversity potentially giving rise to opportunities for growth.
We think that those systems and facilities that can weather the storm and perform well in this environment are likely to gain market share and patient loyalty once we return to more normal conditions. Conversely, poor performance is likely, in our view, to have the opposite long-term effects. Once again, competent management teams are a crucial indicator for which systems are likely to perform best.
1 Bloomberg, as of March 20, 2020. 2 Bloomberg Barclays Municipal Bond Index, as of March 20, 2020.
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