It’s shaping up to be quite a memorable year—and we still have the entire second half of 2020 to go. Last month, the COVID-19 pandemic finally started to abate in the US after months of social distancing and a near shutdown of the economy. As fears of the coronavirus began to dwindle, news of national racial tensions—exacerbated by the senseless death of George Floyd—began to resurface. At month’s end, one crisis was slowly improving while the other was picking up steam—all with the backdrop of an equity market that has largely shrugged it all off. This is in contrast to Wall Street’s major indices tumbling more than 2% on Friday as several U.S. states imposed business restrictions in response to a surge in coronavirus cases.
Recently, Parametric Portfolio Associates published a Research Commentary entitled, “Munis Shine in May,” which we thought would be of interest.
- Munis became the top-performing US fixed income asset class after rebounding to deliver a 3.18% return in May.
- The combination of recent muni market stress and elevated supply caused taxable muni yields and spreads to increase relative to US Treasuries and US corporate bonds.
- In May, 2.5 million jobs were created, which signaled that the federal programs and direct stimulus—particularly the Paycheck Program Protection (PPP)—were working to support a quicker road to economic recovery.
Equity markets seemingly focused on the unprecedented amount of monetary and fiscal stimulus deployed by the Fed and Congress, while the bond market clung to concerns over the timing and strength of an economic recovery. This created a divergence of views—one optimistic and one cautionary— that has to be reconciled soon. Either the equity market will have moved too far too fast, or the Treasury market should no longer be pricing in a global crisis. The next few months will be key to resolving this problem.
Having performed strongly in March and April, the Bloomberg Barclays US Treasury Index lost ground in May with a -0.25% return. Corporates also came back to earth in May after a stellar April, with the Bloomberg Barclays US Corporate Index returning 1.56% for the month. Muni returns lagged in March and April, but they rebounded to become the top-performing US fixed income asset class after delivering a 3.18% return in May. As previously mentioned, equities continued their rebound, with the S&P 500® Index posting a 4.53% return in May. It’s also worth noting that the S&P 500® Index nearly broke even, year to date, by the end of May.
After a severe dislocation in March, the $3.8 trillion municipal bond market is on a steady path of price normalization. Despite the turnaround, there’s still one segment of the market that’s waiting to find its path: the $500 billion portion that’s federally taxable. This opportunity was identified in taxable municipals when new issuance more than doubled from the average run rate. As shown in the chart below, roughly $70 billion in taxable debt came to market in 2019, though the average issuance over the previous five-year period was about $30 billion. COVID-19 might have caused a hiccup in issuance earlier this year, but supply is picking up again—and the surge is expected to continue through the remainder of 2020. The market is expected to surpass $80 billion in total issuance, which presents an opportunity for investors.
Issuers may choose to borrow on a taxable basis and pay a higher interest cost relative to tax-exempt issuance for a variety of reasons. The primary reason is that it allows for more flexibility in the use of the loan proceeds. For example, taxable municipal debt can be used for working capital, to finance for-profit infrastructure or development (private business use), or to bolster unfunded pension plans.
Issuers can also issue taxable debt for cost savings on existing debt. As part of the Tax Cuts and Jobs Act of 2017, municipalities lost the ability to refund or refinance outstanding tax-exempt debt in advance with new tax-exempt bonds. However, the law still allows for refinancing to occur with new issuance of taxable debt. In the current environment of generally low interest rates, issuers can find meaningful savings by refinancing outstanding tax-exempt debt with taxable debt.
Attractive valuations for taxable munis
The combination of recent stress in the municipal market and the elevated supply has caused taxable muni yields and spreads to increase relative to US Treasuries and US corporate bonds. Prior to the surge in supply, taxable muni spreads were tighter than comparably rated corporates. This might have reflected munis’ lower historical default rates.
The chart below shows that 10-year AA-rated taxable munis, which yield 2.18%, have a spread above US Treasuries, that’s 53 basis points wider than similarly rated US corporates, which yield 1.65%. As investors continue to search for ways to enhance yield, taxable munis provide a compelling opportunity relative to corporate bonds without sacrificing credit quality or increasing duration risk.
Our point of view
The fact that 2.5 million jobs were created in May was a major positive and a surprise. It was magnitudes better than Bloomberg’s consensus estimate of a 7.7 million decrease in job totals. Predictions and estimates are lacking reliability in this unprecedented economic period. We can safely conclude from the data that many industries hired (or rehired) in May— with particular strength coming from the leisure and hospitality sector of the economy.
The job increases signal that the federal programs and direct stimulus—namely the PPP—are working to support a quicker road to economic recovery. However, let’s not forget the 20 million jobs lost in April. Some of those job losses will be permanent, with some businesses closing for good. As we saw after the 2008 financial crisis, many unemployed will drop out of the labor force and stop seeking employment. This will have lasting effects on the economy and makes any estimate on the recovery timetable unreliable.
For successful artists, athletes and entertainers, municipal bonds can serve as an all-weather foundation dampening equity market volatility, protecting career earnings and creating a predictable tax-free income stream.
To learn more about municipal bonds or request a copy of the full Research Commentary, please do not hesitate to contact our team directly.
We look forward to continuing to provide useful insights and relevant solutions focused on helping you achieve your greatest financial potential.
Thank you for your continued trust and confidence in Stonebridge.
All the best,
Parametric uses investment science to build and manage systematic investment strategies and to implement custom portfolio solutions providing clients with targeted investment exposures with control of costs and taxes. Based on principles of intellectual rigor, ingenuity and transparency, Parametric seeks to deliver repeatable client outcomes with consistently high levels of service and maximum efficiency. As of April 30, 2020, Parametric managed $287.4 billion in assets on behalf of institutions, high-net-worth individuals and fund investors. Headquartered in Seattle, Parametric also has offices in Minneapolis, Westport, Connecticut, Boston, and Sydney, Australia.
For more information, visit parametricportfolio.com.