Muni market tailwinds turn to headwinds - BlackRock

Muni market tailwinds turn to headwinds

Why would historically stable assets tumble amid Coronavirus fears? BlackRock's municipal bond experts shed light on this unprecedented selloff and the outlook for munis from here.

Peter Hayes, Head of the Municipal Bonds Group Sean Carney, Head of Municipal Strategy

Munis hit turbulence in a flight to safety

Global financial markets sold off sharply and erratically in March as investors braced for the economic impact of the Coronavirus pandemic. While high quality assets such as municipal bonds typically perform well in a risk selloff, volatility this extreme--worse than the height of the Financial Crisis--drove investors straight to cash.

Bond markets broadly faced a liquidity crisis and unprecedented rate volatility. The S&P Municipal Bond Index plummeted more than 10% in just a few days, but recovered just as swiftly as crossover buyers swooped in to snatch up bargains rarely seen within the highly desirable asset class. Municipals ended the month down -3.34%, bringing year-to-date total returns to -0.58%.

Coronavirus fears caused an unusual quick rout in municipal bonds Year-to-date performance of the S&P Municipal Bond Index

Total return

4% 2 0 -2 Jan -4 -6 -8 -10

YTD total return: 3.32% Weighted average price = $110.11 Yield to worst = 1.22%

Feb

Mar

YTD total return: 7.55% Weighted average price = $98.52 Yield to worst = 3.63%

AAA muni yields % (Bond prices and yields move inversely.)

2-yr 5-yr

Muni/Treas % (Ratio of yields on AAA munis vs. Treasuries.)

10-yr 30-yr

March 9 0.45

Selloff 2.07

March 23 2.52

Recovery 1.46

March 31 1.06

Net change 2/29-3/31

0.61

131

734

865

396

469

338

0.49

2.07

2.56

1.47

1.09

0.60

116

533

649

359

290

174

0.78

2.01

2.79

1.46

1.33

0.55

157

208

365

174

191

33

1.38

1.99

3.37

1.38

1.99

0.61

148

104

251

104

147

0

Source: S&P Dow Jones Indices, Refinitiv, Bloomberg, BlackRock, as of 3/31/20. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

April 2020|Municipal market commentary

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A record 60 weeks of inflows abruptly reversed Weekly municipal bond mutual fund flows

$5

0

Billions

-5

-10

-15

-20 Jan 19

Mar 19

May 19

Source: Investment Company Institute, as of 3/31/20.

Jul 19

Sep 19

Nov 19

Jan 20

Mar 20

Demand shifted gears

Municipal bonds delivered stellar performance in 2019 and demand continued to be strong in 2020 before the onset of market distress. A streak of 60 consecutive weeks of inflows to municipal bond mutual funds, totaling $116 billion, abruptly shifted to record outflows in March. Investors moved into cash or reallocated into cheaper asset classes as volatility skyrocketed and interest rates fell to all-time lows, which essentially negated the tax benefits of municipal bonds.

Looking back at past external market shocks--the Financial Crisis, predictions of Meredith Whitney, taper tantrum, and the most recent U.S. presidential election--we find that the duration of these outflow cycles have averaged 24 weeks, and the magnitude has averaged ~62% of the previous inflow cycle. These observations lead us to believe that the current outflow cycle is likely to continue.

Outflows put the market in a holding pattern

The sudden and massive outflows overloaded dealer appetite. In the secondary market, bid-wanted activity accelerated as fund managers looked to raise cash ahead of anticipated shareholder redemptions. An average daily bid-wanted volume of $590 million in January and February shot up to more than $2 billion per day in March. Amid broad market stresses, dealers were less willing and able to take more municipals onto their balance sheets, resulting in incredibly wide bid-ask spreads.

The new issue market essentially froze. Deals were undersubscribed (versus the year-to-date average subscription rate of 5.5x), causing issuers to postpone the majority of the forward calendar. As a result, the market saw only $17.2 billion in issuance in March, significantly below the month's five-year average of $31.1 billion, bringing year-to-date total issuance to $86.7 billion, up only 14% year-over-year.

Secondary market selling surged as investors raced to cash Aggregate par amount of muni bond daily bid-wanted activity

$4,500

Millions

3,000 1,500

0 2018 Bid-wanted par amount Average

Source: Bloomberg, as of 3/31/20. 2

2019

2020 USRMH0420U-1141310-2/4

Market liquidity seized amid a spike in short-term lending rates Weekly dealer inventory of variable rate demand notes and SIFMA rates

$30

6%

20

4

Billions SIFMA

10

2

0

Jan 19

Mar 19

VRDN Inventory SIFMA

May 19

Jul 19

Sep 19

Nov 19

Source: Bloomberg, Bank of America, Securities Industry and Financial Markets Association (SIFMA), as of 3/31/20.

Jan 20

0 Mar 20

And then...the liquidity engine seized

While high yield funds accounted for a large portion of the outflows, the extreme volatility led to heavier trading in the most liquid segments, i.e., higher quality and shorter duration assets. Dealers were inundated with variable rate demand notes (VRDNs) in excess of $30 billion--roughly 22% of outstanding VRDNs. With inventories elevated to six times their norm, short-term SIFMA rates shot up to 5.20%, pressuring leveraged vehicles in the market. The rate spike was technical in nature and not driven by credit nor structural concerns. VRDNs are highly liquid short-term vehicles backed by letters of credit from tier 1 banks. Rates have since normalized, alleviating pressure in this area.

But munis quickly regained altitude

The liquidity-driven market dislocation created a buying opportunity in March. Attractive relative valuations, with muni/Treasury ratios well above their 2008 highs, spurred aggressive buying among crossover and institutional investors, while higher yields enticed some retail investors, albeit to a lesser degree. At the same time, sentiment improved as a variety of stimulus measures began to take shape, including liquidity facilities from the Fed and the CARES Act, which provides funding to municipal entities and permits Fed loans to and investments in municipalities.

Triage of municipal sectors

Municipals will experience some stress alongside the U.S. economy. Muni issuers must continue to operate despite revenue uncertainty. Some segments will face daunting financial challenges and federal support may be insufficient. Issuers with solid balance sheets will need to draw down reserves to meet obligations. Safety net hospitals, senior living facilities, mass transit and airports with limited resources will require funding from the states and municipalities they serve. Non-rated stand-alone projects may experience significant credit deterioration. As the recent market dislocations lead to attractive buying

opportunities, investors will need to be highly selective and carefully consider emerging risks.

High yield credits will be the most vulnerable, especially retirement communities, nursing homes, casinos, hotels, regional trains, shopping centers and resource recovery plants. Overleveraged local governments and small private universities are also likely to struggle, along with airports, toll roads, mass transit and rural/single-site hospitals. States and cities that rely heavily on tourism, narrow sales and personal income taxes, and oil prices will be strained, as well as those with poorly funded pension systems.

The good news is that most states and municipalities were in excellent fiscal health before the crisis. We expect ongoing stability in high-quality states as well as school districts and local governments as property taxes have proven resilient in past downturns. Essential services such as power, water and sewer are protected segments. State housing authority bonds also should not be impacted.

The municipal market is a high quality asset class with a majority of its bonds rated AA or higher. A prolonged recession would likely mean a pickup in the number of defaults, although the aggregate market value should be marginal and concentrated within high yield and nonrated. Credit quality within investment grade will remain strong even if ratings migrate from AA to A.

Strategic views

We maintain a slightly defensive posture in muni bond positioning as we expect the outflow cycle is in its early innings. Managing cash balances in anticipation of future redemptions while also taking advantage of opportunities will be a balancing act. Forced selling among market participants may present opportunities to gain exposure to credits that typically do not trade in sizable blocks.

3 USRMH0420U-1141310-3/4

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Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income from tax-exempt bonds may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Past performance is no guarantee of future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2, 2020, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.

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Prepared by BlackRock Investments, LLC, member FINRA.

Not FDIC Insured ? May Lose Value ? No Bank Guarantee

Lit No. MUNI-OUTLOOK-0420

OE12014T-0420

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