HOW HAS THE COVID-19 CRISIS IMPACTED THE MARKET?

Going into the crisis, the municipal market was in very strong technical shape. After the Tax Cuts and Jobs Act passed in 2017, the market saw consistently strong demand combined with relatively constrained tax-exempt new issue supply. As a result, prior to March 2020, quality and sector spreads were compressing and many investors were reaching for yield. Using fund flows as a proxy for demand, municipal funds saw 60 consecutive weeks of net shareholder inflows, amounting to nearly $114 billion in the 14 months preceding the March upheaval. Fund flows reversed when the COVID-19 crisis hit in March, and more than $40 billion exited the market in just a three-week period. Pressure from redemptions produced a severe liquidity squeeze, exacerbated by leveraged funds reeling from the sharp rise in rates. Yields on high-grade bonds soared by 175 basis points in a single week. And quality spreads, which had seemed to be on a one-way street of tightening, widened by multiples as the economic environment turned abruptly negative and increasingly uncertain.

IS THE DAMAGE IN THE MARKET MORE REFLECTIVE OF A LIQUIDITY EVENT OR OF A FUNDAMENTAL CREDIT DETERIORATION?

The initial stage of the selloff was driven by demand for liquidity. Rates in the tax-exempt money market segment spiked five-fold, reflecting the squeeze on leveraged market participants and the acute demand for cash across all markets. However, the inclusion of municipals in the Federal Reserve’s support facilities and a break in redemption activity quickly helped normalize short-term funding markets.

Now that we’re several weeks past the liquidity crisis, credit and sector valuations appear to reflect deteriorating fundamentals. The economic shutdown has caused a falloff in revenues and investors are concerned about the longer-term prospects for large sectors of the municipal market, including mass transit, hospitals, airports, convention centers and higher education, among others. State and local issuers have historically had a very low default rate (0.10% for investment grade issuers after 10 years) and experienced a stronger average recovery rate than comparably rated corporate borrowers. However, we do not think investors can afford to be complacent about municipal credit in the current downturn; we believe the market could experience more pain than in previous downturns as the COVID-19 crisis may induce behavioral changes that negatively impact credits in unanticipated ways.

WHAT RISKS AND OPPORTUNITIES ARE YOU SEEING AS THE ECONOMY BEGINS TO RE-ENGAGE?

The damage to credit fundamentals is widespread. Social distancing has upended economic activity to a significant degree and in a manner never before contemplated, contributing to credit deterioration across many sectors.  When and how those requirements can be eased could determine the financial viability of some issuers going forward.  We believe cash is critical over the near term. Many issuers with weak balance sheets will likely find themselves under pressure from the degree of revenue loss, whether it is an abrupt reduction in consumption activity like airport usage, sales taxes, elective surgeries, etc., or income and property tax declines, which will occur over a longer time frame. We are attempting to avoid credits with narrower revenue streams, as these issuers typically have limited financial flexibility to address fundamental credit deterioration. We believe competitive position is also critical as the market ferrets out expected winners and losers coming out of the downturn.

Turning to potential opportunities, we are evaluating the airport sector for credits with a strong cash position and with carrier agreements that can provide additional means for recovering lost revenues. The hospital sector is another area where revenues have declined precipitously, but the sector offers many issuers with very strong balance sheets and dominant competitive positions. Higher education is a challenged sector where issuers’ competitive positions can be delineated fairly clearly. While the sector has generally weaker fundamentals due to demographic trends, colleges and universities with strong student demand and good selectivity characteristics should be able to recover fairly quickly. In general, we believe the current credit dislocation can provide a better opportunity to capture potential alpha in the municipal market than we’ve seen for some time.