- The municipal bond market came under significant pressure when investors began selling assets.
- The Federal Reserve has intervened to improve liquidity in the muni bond market.
- The Fed's action is a net positive for the market and for states, counties, and cities. But challenges remain.
- Historically, the default rate of municipal bonds is very low.
When investors responded to the spread of the COVID-19 pandemic in the US and the oil price collapse by selling stocks and bonds on an almost indiscriminate basis, municipal bonds got caught in the crossfire.
Munis have long been popular with investors who seek reliable tax-free income and historically low credit risk, and their prices had been surging since the 2017 tax reform package eliminated many tax deductions. But those virtues and their recent strength meant little as they were swept up in the dash for dollars that began as February ended.
Bonds from fiscally healthy places such as Utah and Georgia fared better than those from states such as Illinois, New Jersey, and Kentucky, which face significant fiscal challenges. But nearly every corner of the muni market suffered an abrupt shock, and issuance of new bonds ground to a halt as buyers disappeared.
Even in the best of times, the $3.9 trillion muni market is less liquid than other fixed income markets. The selloff threatened not only to raise borrowing costs for states and cities but also to potentially put their ability to borrow in question even as tax revenues dried up along with business activity and consumer spending.
Fed to the rescue
To backstop states and other municipal issuers, the Federal Reserve announced on April 9 that it will buy up to $500 billion of muni bonds from states, counties with populations of at least 2 million residents, and cities with at least one million residents. Only 10 cities and 16 counties nationwide are big enough to qualify, but states may use the proceeds from purchases by the Fed to support counties and cities as well.
Earlier, on March 20, the Fed had previously announced that it would expand its purchases of municipal bonds to include those with maturities inside of one year. A few days later, on March 27, President Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act which authorized the Fed to buy municipal bonds of any maturity. The CARES Act also appropriated $274 billion to muni issuers, including state and local governments, health care systems, transit systems, and educational institutions.
Municipal budgets still face significant challenges due to lower tax revenues that result from widespread shutdowns of businesses. But Fidelity's government relations office says the passage of the fixed income market support provisions in the CARES Act are helping to stabilize the operations of the fixed income marketplace, and sees the liquidity facilities announced by the Fed on April 9 as a net positive for the municipal fixed income market.
Paul Maguire, Institutional Portfolio Manager with Fidelity's fixed income division, says that liquidity in the muni market has improved significantly, primarily because of the monetary and fiscal policies adopted by the federal government in the past few weeks. "The Fed has done a great job of identifying the liquidity bottlenecks in the market and of being proactive in addressing them. Still, while pockets of liquidity now exist, challenges remain."
What can muni investors expect next?
Maguire says the federal government's combination of public policy initiatives has gone a long way toward improving the liquidity of the municipal bond market and returning it to some state of normalcy.
Still, concerns remain. How long will it be before states reopen their economies? Will the economic recovery be V-shaped or U-shaped? Will there be a recovery at all, given the potential of the coronavirus to spread again, either when the economy reopens, or perhaps when cold weather returns? How will the psychological effects of the COVID-19 pandemic affect people's behavior in the future? Will they still want to go to the movies, to restaurants, to sporting events, or will a hangover effect cast a pall over the economy? No one knows the answers to these questions, and until they do, there will be uncertainty regarding the prices of investments, including municipal bonds.
Looking back to look forward
Despite the challenges facing many muni bond issuers, investors should remember that investment-grade municipal bonds historically have experienced exceptionally low default rates, especially relative to US corporate bonds.
Moody's Investors Services has studied default rates for municipal bonds and US corporate bonds from 1970 to 2018. During this time, the average cumulative default rate for investment-grade municipal bonds over all rolling 10-year periods was 0.10%. That means that of all the investment-grade municipal bonds at the beginning of the 10-year period 0.10% of the bonds based on market capitalization defaulted by the end of the 10-year period1.
The average cumulative default rate for US corporate bonds over similarly rolling 10-year periods was 2.28%—almost 23 times higher. High-yield municipal bonds defaulted at a much higher cumulative rate over the rolling 10-year periods—specifically, at an average rate of 7.47%. But even this rate was only about one-fourth the cumulative default rate of US corporate high-yield bonds, which averaged 28.79%.
Finding investment ideas
Investors attracted to the historically low default rates and tax advantages that munis offer can buy individual muni bonds, but professionally managed mutual funds, exchange-traded funds, and separately managed accounts offer exposure to a wider variety of issuers and maturities than most investors would be able to achieve by buying individual bonds.
Fidelity has a number of tools to help investors screen through mutual funds and ETFs for research ideas. You can run screens yourself using the Mutual Fund or ETF screeners on Fidelity.com. Below are the results of a sample screen for national investment-grade municipal bond funds with Morningstar ratings of at least 3 stars (these are not recommendations of Fidelity).
American Funds Tax-Exempt Bond Fund® Class F1 (AFTFX)
BNY Mellon Opportunistic Municipal Securities Fund Class A (PTEBX)
Parametric TABS Short-Term Municipal Bond Fund Class A (EABSX)
T. Rowe Price Tax-Free Short-Intermediate Fund (PRFSX)
The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.