• Cities and state across the country hurtle towards the worst fiscal crisis in decades
  • The bond rally in May offset the big loss the asset class suffered in March
  • State and city governments will balance budgets which were hammered by a plunge in tax collections

Municipal bonds -- debt securities issued by state, municipality or county governments to finance capital expenditures -- are poised to deliver their best monthly performance in more than a decade in May 2020 – despite the chaos triggered by the coronavirus pandemic and business shutdowns.

As cities and state across the country hurtle towards the worst fiscal crisis in decades amid an unprecedented economic collapse, the $3.9 trillion muni bond market has gained 2.96% for the month through Friday, according to the Bloomberg Barclays Muni Bond index.

The bond rally in May offset the big loss the asset class suffered in March – as yields fell to 60-plus year lows (yields drop when bond prices rise). On Friday, the yield on the benchmark 10-year tax-exempt muni debt tumbled 5 basis points to 0.83%.

In May through Friday, the iShares National Muni Bond ETF (MUB), the largest exchange-traded fund tracking muni-bond markets, gained 1.03%.

In April, MUB dropped 1.38%; while in March, the ETF plunged 2.98%.

Bloomberg reported that the May rally has been facilitated by an inflow of cash into muni bond funds – even the riskiest ones – due to efforts by the Federal Reserve to protect the markets from another liquidity crisis.

In addition, as more states start to reopen some businesses and coronavirus deaths appear to be leveling off, investor sentiment has improved.

Patrick Luby, a muni bond analyst with CreditSights Inc., a financial research firm, said, state and city governments are expected to seek to balance budgets which were hammered by a plunge in tax collections.

“The serious and thoughtful way in which many [muni bond] issuers are beginning to wrestle with what are going to be really painful decisions from a financial and human perspective is constructive to the [bond] market,” Luby said.

Most state governments are predicting significant budget shortfalls in the coming years, which will no doubt mean massive layoffs to cut costs.

The health of the muni bond market is intimately linked to the viability of hundreds of thousands of state agencies and businesses, including public transit agencies, airports, hospitals and colleges – many of which have suffered big losses due to the pandemic shutdown.

Natalie Cohen, president of National Municipal Research Inc., estimated that the coronavirus pandemic may cost states up to $200 billion in revenue shortfall; while counties could face up to $114 billion in lost revenues and $30 billion in additional expenditures. New York state alone faces a $14 billion deficit.

However, muni bonds are still likely to avoid default since local government agencies have the power to increase taxes in order to recoup financial losses. Also, bond payments account for a relatively small portion of local governments’ budgets.

Defaults by local governments are rare – since the Great Depression no state government has defaulted and only a few local jurisdictions fell into bankruptcy during the recession of 2008.

Since 1970, some $72 billion of municipal bonds rated by Moody’s Investors Service have defaulted – with the bulk ($66.5 billion) of that amount accounted for by the bankrupt governments of Detroit, Jefferson County, Ala., and Puerto Rico.

Despite muni bonds’ good performance in May, the unpredictable nature of the pandemic will likely keep markets volatile and extremely risky.

“[Bond] prices move up or down with greater velocity when you’ve got less liquidity,” said Luby. “There’s still an enormous amount of uncertainty in the market.”

Barron’s reported that while the Federal Reserve has commenced purchasing corporate bonds – thereby calming volatility in this sector – muni bonds remain beset by volatility.

Barron’s wrote that central bank assistance will be crucial for muni bond markets, citing that state and local governments will need as much funding as possible to stabilize. Even before the coronavirus pandemic, local governments were pressured by both unfunded pension liabilities and budget battles.

“COVID-19 now poses the most severe challenge to municipal credit in living memory,” wrote Thomas McLoughlin, manager of the fixed income research team at UBS Global Wealth Management. “While the incidence of fiscal distress is rising, the real test will come next year when budget cuts will dominate the headlines.”

Barron’s cited the case of the state of Illinois, which issued $800 million of bonds last week, paying coupons of 4.88% to 5.75% -- sold at spreads almost 1% higher than muni bonds with comparable ratings.

However, even if Illinois’ bonds are downgraded to junk, it will still qualify for the Fed’s liquidity facility – although it will be expensive. Municipalities at the lowest end of the ratings spectrum will have to pay as much 5.9 percentage points above benchmark rates.

“The interest rate on [muni] notes must be a penalty rate, meaning a rate that is a premium to the market rate in normal circumstances, affords liquidity in unusual and exigent circumstances, and encourages repayment of the eligible notes and discourages use of the facility as the unusual and exigent circumstances that motivated the program recede and economic conditions normalize,” the Fed explained.

The bottom line is that municipalities will have to pay above-market rates in interest payments and fees to avail themselves of the Fed’s facility.

“The unprecedented monetary and fiscal support for the economy will allow most municipal bond issuers to recover,” wrote McLoughlin. “[But] the Senate appears more reluctant to write a blank check to states and local governments and is likely to demand the inclusion of provisions to shield businesses and health care providers from coronavirus claims. Enactment of the next round of legislation is likely to be more challenging than the first four [rounds].”

Mark Hulbert, founder of Hulbert Ratings, opined that while the muni market has calmed down after the turmoil of March, they don’t yet represent an attractive investment opportunity.

“The coronavirus pandemic… has imperiled the finances of many muni bond issuers in particular states and municipalities,” Hulbert wrote. “This concern about default risk has been exacerbated by comments in April by Senate Majority Leader Mitch McConnell that states and cities should declare bankruptcy rather than rely on a federal government bailout.”

But Hulbert thinks the notion of a default risk is likely exaggerated.

“Legal experts contend that it would be unconstitutional for the federal government to allow states to declare bankruptcy,” he wrote. “The last thing the federal government wants right now (despite what it might say) is for there to be a rash of state and city bankruptcies. And though there is debate in Washington over the specifics of a stimulus program for states and localities, most seem to believe that some sort of stimulus will be passed.”

Hulbert proposed that one’s expectations of a default risk should guide investors about which fixed income asset class they should buy now.

“If you’re comfortable that default risk isn’t higher for corporates than for munis, you would want to favor investment grade corporates for the fixed income portion of your portfolio,” he said. “To the extent you don’t, munis become increasingly attractive.”