Municipal bond market update: a crisis averted
As of this writing, market dislocations and economic disruption from the coronavirus are the order of the day. However, we believe the U.S. Federal Reserve's (Fed’s) historic policy backstop and the government’s US$2+ trillion fiscal stimulus package could go a long way toward shoring up market sentiment. And yet caution remains warranted for muni bond investors. We see widely divergent risk profiles across and within different muni bond sectors, and these bear close monitoring as the situation progresses.
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.
important disclosures
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against a loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams, along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
These materials have not been reviewed by and are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.
Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd., which is authorized and regulated by the Financial Conduct Authority; Manulife Investment Management (Ireland) Ltd., which is authorized and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U). Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G). South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC, and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates, under license.
514743
