The muni market overall is set for more gains, but some bonds are riskier than they appear

Municipal bonds outperformed Treasurys in June and they could continue to see good demand this summer, even as the pandemic limits economic activity and strains state budgets.

The muni market was hit hard during the market collapse in February and March, and the $3.8 trillion asset class has not fully recovered. Strategists say it could be subject to more volatility, depending on the course of the virus and the economy.

Bank of America says that munis have underperformed all U.S. taxable bond indexes in the first half on an after-tax basis, making munis the cheapest asset class.

“We are positive on the recovery of the prices, but there will still be more downgrades. That’s the cautious part,” said Yingchen Li, Bank of America co-head municipal research.

Strategists say a catalyst for the market this summer should be another round of stimulus from Congress, in the form of direct aid for state and local governments.

While munis returned about 2% in the first half of 2020, according to the Bloomberg Barclays Municipal bond index, not all bonds are created equal, and the impact of the economic hit from the coronavirus is affecting issuers differently.

“In terms of the bond market and muni market itself, we think investors should be focused on higher rated issuers,” said Cooper Howard, director of fixed income strategy at Schwab Center for Financial Research. “We think there are opportunities to dip into single A rated credits, of issuers in sectors that have stable revenues.”

Many investors buy funds and ETFs, and strategists say a portfolio of muni bonds should be diverse. That means they should contain a mixture of bonds, like state and city general obligation bonds, plus bonds from other types of issuers like water and sewer authorities, the best performers so far this year, according to Bloomberg Barclays data.

Those with the lowest returns in the first half include hospitals and transportation, which include transit systems and airports.

The market has been helped both by fiscal aid under the CARES Act and by a Federal Reserve program targeted to support the muni market.

Jeffrey Lipton, head of Oppenheimer municipal research and strategy, said munis were up 82 basis points overall in June, while U.S. Treasurys returned just 9 basis points.

“Right now, we’re going through the seasonal technicals, where you have outsized demand, but you don’t have supply to meet the demand. That’s part of what’s driving performance, the market technicals,” said Lipton. “But also the fact that you’ve had rather aggressive, appropriate and scalable monetary and fiscal policy. That taken together has alleviated much liquidity concerns, as well as credit concerns in the municipal market.”

Congress is expected to consider the next phase of stimulus later this month to help state and local governments deal with the budget strain from the virus, coupled with a loss of revenue.

While Democrats have targeted $1 trillion for state and local governments, political strategists say the amount will more likely be less than half of that. 

“If they get more money, it will be enough,” said Ian Rogow, co-head of muni research at Bank of America, along with Li. Rogow said state and local governments came into the crisis well-positioned in terms of reserves. “2019 was one of the strongest ratings years in the post-financial crisis era…To the extent, they get a decent amount of funding from Congress, it will forestall the worst budget cuts.”

BofA strategists said GO bonds outperformed the revenue index as essential services, which include education, water and utilities were strong. But airports, transportation, multi-family, rental abd lease and healthcare were weak.

For the second half, they see little movement in AAA rates but credit spreads should narrow further in July.

Li said munis are still undervalued by one important metric. He said the difference between the yields of the highest rated investment grade AAA munis and the lowest investment grade, BBB, are still about 60% wider than they were when the market started to sell off in February.

As for state bonds in the first half, the underperformance of Illinois, New Jersey and New Hampshire weighed on the category. New Jersey and Illinois have budget issues and high pension obligations.

Howard said New Hampshire bonds are tied to hospitals, a group that got slammed during the market sell-off as investors reacted to fears about the virus impact.

Investors should beware of potential ratings downgrades, but also bankruptcies though they are rare in the muni world.

BofA cited a study by Moody’s that found there were just 113 defaults for Moody’s rated muni issuers between 1970 and 2018. About 60% of those defaults were in health care and housing. There were only 10 GO defaults by school districts, counties or cities during that same time, and none involving states, which cannot go bankrupt.

BoA strategists say among the bonds they like are cities that have a high exposure to the technology sector, and they advise investors to avoid high yield and small private colleges. They also expect the taxable munis to outperform the tax free this summer.

Schwab’s Howard said he favors a portfolio of GO bonds and essential services revenue bonds, like water authorities that have guaranteed revenue streams.

Investments in the education sector, about 7% of the investment grade market, fit in a balanced portfolio.

But the impact of the coronavirus has put a strain on schools, and Howard said investors need to discern between how different schools are rated and how they are positioned to weather a year where they may collect less revenues and spend more to provide education in a Covid world. 

The outlook is even more complicated by the uncertainty about the next semester and the different approaches schools and states are taking to classroom learning. Some students may find they may take a gap year, leaving some schools short of revenue.

The Trump administration is requiring international students to physically attend classes or leave the country. For some schools, tuition from these students is an important part of their revenues. Both MIT and Harvard University sued the Trump administration Wednesday over the ruling.

Strategists say even before the coronavirus, it was generally safer to stick to the bonds of Ivy League schools and nationally recognized brand name schools over smaller private institutions. Public schools tend to be higher rated, in general in the A+ category, but private schools ratings are more wide-ranging.

Public institutions are separate credit entities from their states, but they benefit from the fact they have state funding. They could also come under pressure because state budgets are pinched and higher ed is a place to look for cutbacks.

Schwab said public universities collect about 22% of their revenues from state aid. Another 48% is student generated revenue, but about 85% of private school revenues are student generated.

“In higher ed, the bifurcation plays out in those that are higher rated, those tend to be schools with huge national draws or niche markets, versus the smaller private school with heavy dependence on tuition. That’s where I’d be cautious,” said Howard.

Howard said the education bonds have been lumped together so there is opportunity for investors willing to distinguish between them. 

Strategists say that is also true of other sectors that were beaten down, and investors should look for the better names in the hospital and transportation groups, for example.