Last week, we discussed the unprecedented moves in the municipal bond market with over 300 investment advisors. We polled the audience to learn their expectations for defaults in the municipal market in the coming year and where they see potential investment opportunities. Below are our questions, their responses, and our thoughts and explanations.
Q: What is your view of municipal defaults in the next year?
A: Forty percent of advisors polled believe there will be a significant increase in municipal defaults in the next 12 months.
Invesco Fixed Income view
While this sentiment doesn’t surprise us (given the current uncertainty and recent headlines), we do not believe there will be a material rise in municipal defaults in the next 12 months. While there may be isolated pockets of default in the future, we believe the vast majority of municipal issuers will remain current on their scheduled principal and interest payments for the foreseeable horizon for the following reasons:
- Municipal bonds generally provide essential public services, such as healthcare, education, transportation and infrastructure projects. They afford strong legal protection to bond holders to assure payment, and typically have strong collateral backing including, but not limited to, working capital, debt service reserves, mortgages and liens.
- Municipalities generally operate with reserves, borrowing authority and operational flexibility (in other words, they can cut services or raise fees and taxes), which allows them to navigate economic disruption.
- The federal government has acted in previous crises and is acting now. The recently passed CARES Act offers $400 billion in support to municipalities and the Federal Reserve has implemented multiple programs to provide liquidity to the municipal market and municipal issuers and is working to purchase municipal securities.1
- We expect additional federal action to come in the form of the fourth congressional bill and additional plans under consideration by the Fed.
- Many municipal issuers were in strong financial shape before the pandemic, as the economy was enjoying an unprecedented prolonged economic expansion.
While the possibility of defaults certainly increases in times of stress, a recent Standard & Poor’s study uses nearly 50 years of data to show that municipal bonds have historically weathered storms.2 The study covered the period of 1970-2018 and showed that BBB-rated municipal bonds defaulted less often over the period than AAA-rated corporate bonds. This was despite a significant number of dramatic market shocks over that timespan: the oil crisis of the 1970s, Black Monday in 1987, the European sovereign debt crisis in 2010-12, September 11 in 2001, the bursting of the tech bubble in 2000, when analyst Meredith Whitney appeared on 60 Minutes in 2010 and predicted 50 to 100 US counties, cities, and towns in the United States would have municipal bond defaults totaling hundreds of billions of dollars, and the global financial crisis in 2008 (to name a few).
Q: Where are municipal opportunities?
A: Fifty-seven percent of respondents saw the best opportunities in investment grade municipals.
Invesco Fixed Income view
The municipal market is not a quoted marketplace. It is an over-the-counter market where, on average, approximately 1% of the over 1 million securities trade on a given day.3 Emotional responses to headlines and dramatic price movements can cause investors to sell into illiquid markets, resulting in many bonds being sold below their fair value. In the current environment, we believe this dynamic has created buying opportunities, as we remain confident the municipal market and the US economy will eventually recover.
We expect municipal issuers to adjust services, raise fees and tap reserves while Federal programs begin to be implemented. We also believe that valuations have become attractive in many cases. In March, 10-year, AAA rated municipal bond yields traded as high as 350% of US Treasury yields, levels not seen even during 2008.4 The historical average is below 100%.5 We believe this ratio will eventually converge to historical levels, and that will result in favorable municipal bond returns versus other haven assets.
Where does Invesco Fixed Income believe there are opportunities? We currently see potential opportunities across investment grade and high yield. We look to find the most optimal bond structures and credits at spreads where we believe we will be compensated for the risk being assumed. We also believe Invesco Fixed Income’s dedicated research team sets us apart. Our team places an internal rating on every bond we hold, allowing our portfolio managers to sell a bond that we internally rate lower than the rating agencies, and pursue bonds for which our outlook is more positive. In our view, that allows us to identify and potentially capture opportunities with attractive return potential.
Written with contributions from David Richardson, Senior Portfolio Manager, and Nicholas Henry, Client Portfolio Manager.
1. Source: Coronavirus Aid, Relief, and Economic Security Act
2. Source: Standard and Poor’s data through December 31, 2018
3. Source: Municipal Securities Rulemaking Board: Analysis of Municipal Securities Pre-Trad Data from Alternative Trading Systems, October 2018
4. Source: Thomson Reuters TM3, as of March 31, 2020
5. Source: Thomson Reuters TM3, as of March 31, 2020
All or a portion of the fund’s otherwise tax-exempt income may be subject to the federal alternative minimum tax.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Securities which are in the medium- and lower-grade categories generally offer higher yields than are offered by higher-grade securities of similar maturity, but they also generally involve more volatility and greater risks.
Investing in municipal securities issued by entities having similar characteristics may make the fund more susceptible to fluctuation.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
The opinions referenced above are those of the authors as of April 9, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation.
NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE
Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask their advisors for a prospectus/summary prospectus or visit invesco.com/fundprospectus.