There is an old axiom that the month of March comes in like a lion and out like a lamb. Based on what transpired in the financial markets in March of 2020, the phrase has been turned on its proverbial head.
The stock market provides a good window into March’s volatility as well as that of the first quarter of the calendar year. The S & P 500 closed down 12.50% last month – its worst month since October of 2008. In fact, the Index experienced its worst quarterly performance since fourth quarter 2008 and the worst first quarter ever with a decline of approximately 20%. Generally speaking, U.S. stock market indexes are down roughly 20% – 25% from their recent all-time highs in mid-February. It is also now common to see daily volatility of +/- 5.00% with large intraday swings. Investors have taken some solace this holiday-shortened week as stocks have posted some of their highest weekly gains, dating back to 2009. To illustrate the larger point, a broad measure of stock volatility – the “VIX” Index (higher number = higher price volatility) – was in the mid-teens the middle of February, the mid-30s as we entered March, and peaked at over 80 around March 16. It now stands in the mid-40s.
The fixed-income market has by no means been spared. While U.S. Treasury yields are down since the beginning of March, it’s been a tumultuous ride. At the outset of March, the 3-month U.S. T-bill was yielding about 1.25%. It now yields 0.15%, which is up from a recent low of about 0.00% (the 90-day T-bill traded at negative yields on an intraday basis in late March). The 2-year Note trades at 0.25%, down from 0.85% at the beginning of March and as high as 1.60% at the start of the calendar year. Similarly, the 5-year note has declined from 0.90% to 0.45% and the benchmark 10-year from 1.10% to 0.75%. In the last three weeks, the 10-year has traded in a range of 0.54% (its all-time low) to 1.18%. The 30-year is down 40 basis points from 1.65% to 1.25%, posting an all-time low of 0.99% on March 9.
Other segments of the bond market have demonstrated far higher levels of illiquidity and volatility, especially short-term instruments in the corporate and municipal markets. For example, although commercial paper (fixed-rate debt with original maturities of 270 days of less used for working capital) is typically considered the domain of high-quality creditworthy issuers, corporate and municipal commercial paper have all but stopped trading, making it almost impossible for issuers to re-market and roll over maturing issues. In another example, the municipal variable rate market had one of its worst periods on record with yields soaring from around 1.25% to over 5.00%. Short-term tax-exempt yields have since retreated to under 2.00%, but the volatility remains.
It was also during the month of March that federal and most state authorities enacted various forms of “stay-at-home” orders in reaction to the coronavirus pandemic, essentially putting the brakes on the U.S. economy. Late February and March saw a huge whipsaw in municipal bond net fund flows. Municipal bond funds enjoyed positive net flows for a record period, dating back to about late 2018. Fast forward to March 2020, over $40 billion on net was pulled from long-term municipal funds across all categories – nearly unprecedented in any environment in terms of both magnitude and speed. Cash had essentially become the most valuable asset class over a three-week period, leading into the beginning of April.
As investors have pulled their money from municipal bond funds, fund managers must raise cash to meet these redemptions. The result was an almost crippling torrent of “bids wanted” in the secondary market and a scramble for liquidity on the part of institutional managers and bond dealers. In fact, a number of different information outlets reported that secondary trading in municipals reached some of its highest levels ever in terms of both number and dollar amounts of trades.
This has been an extremely difficult backdrop for the new issue market. New issue volume the week of March 9 was $8.3 billion – about average for the year, up to that point. In the last three weeks new issue volume has collapsed to $2.5 billion, $4.6 billion and $3.9 billion, respectively. The vast majority of transactions in both the competitive and negotiated market were postponed or placed into “day-to-day” mode as the market seized up and lacked any true price discovery. During the weeks of March 16 and 23, there were few competitive sales. The Bond Buyer reported that new issue activity in the Month of March was down nearly 40% year-over-year. Those that proceeded priced at reasonable yields, given the circumstances. However, there were far fewer bids and those bids had high dispersions in pricing with cover bids well over the winning bid and sometimes more than 1.00% between best and worst. Underwriting spreads increased almost 200%, as dealers were seeking to protect themselves should they have to take bonds into inventory. To be clear, the market is not closed, just very selective. Based on a number of estimates, there is now a backlog of approximately $18 billion in deals on the primary calendar essentially on a “day-to-day” basis.
This week has brought some glimmers of normalcy, as issuers have continued with both competitive and negotiated sales. The number of bidders on competitive sales has increased materially. Bid pricing is much tighter and underwriting spreads have returned to those seen prior to March. By no means has the market fully recovered, but there does seem to be a measure of stability returning, in part due to strong policy responses from the federal government and the Federal Reserve.
Indeed, one can certainly point to reduced volatility in the fixed-income market as a precursor to this more positive week. The President signed the CARES Act into law, which establishes funding allocations to states and provides for loan guarantees to small businesses affected by COVID-19. The Federal Reserve also announced a number of programs designed to provide additional liquidity to securities markets, including the municipal market. The Fed has intervened in the short-term municipal market, immediately improving market behavior. While the Fed now has authority to intervene in the long-term municipal market, there does not seem to be an explicit plan to do so. On the morning of April 9, the Federal Reserve formally announced it would provide up to $500 billion in lending to states and municipalities through a Municipal Lending Facility under a broader $2.3 trillion program.¹ The Fed’s news release states: “The facility will purchase up to $500 billion of short term notes directly from U.S. states (including the District of Columbia), U.S. counties with a population of at least two million residents. Eligible state-level issuers may use the proceeds to support additional counties and cities. In addition to the actions described above, the Federal Reserve will continue to closely monitor conditions in the primary and secondary markets for municipal securities and will evaluate whether additional measures are needed to support the flow of credit and liquidity to state and local governments.” While the statement is silent on specifically intervening in the long-term securities market (however that may be defined), investors will see the Fed’s backstop as a benefit, which will help to enhance liquidity.
Even with these positive anecdotes, there’s still a long way to go towards stabilizing markets. A common measure of the relative value of municipals to taxable alternatives is the muni-to-treasury ratio, which measures the percentage of tax-exempt yields to comparable-term Treasuries. In this context, the municipal market is not pricing favorably and well outside of traditional norms. In fact, these ratios are at historically high levels. The ratio at 2-years is over 500%, 300% at 5-years, 275% at 10-years and 200% at 30 years. Prior to March, the ratio at 10-years was roughly 75%, which was low by historical standards and a result of changes in tax law in 2017. In the past, we would expect so-called “cross-over buyers” – those that don’t necessarily care about tax-exempt interest, just absolute return – jumping into the muni market to scoop up what they would consider to be screaming bargains at these levels. However, the paralysis and uncertainty related to the coronavirus pandemic has significantly dampened investor appetite across many asset classes.
Another aspect of timidity on the part of would-be buyers is undoubtedly related to concerns over municipal credit that are likely to present themselves over the coming weeks and months. However, the “municipal market” is characterized by a wide range of issuers and credits subject to vastly different stressors. Local units of government that issue essential purpose revenue and general obligation bonds will not be unscathed, but certainly represent much more resilient credit profiles than hospitals, higher education, airports, convention centers, transit systems, and other sectors where the most acute pain from the economic shutdown is being felt. Just last week, S & P Global was the first credit firm to transition their outlook on the entire municipal sector to “negative,” including states and local governments (including public schools). S & P notes that states and local governments entered what will almost undoubtedly be deemed a recession with strong financial profiles. This strength will be subject to varying degrees of degradation, depending on an issuer’s revenue and expense profile. For example, those with a higher proportion of funding through generally applicable property taxes will likely not experience as much stress as those with exposure to sales and income taxation. Tourism dependent issuers carry their own specific set of risks in this environment.
Only time will tell the depth and breadth of impacts the pandemic will have on governmental entities. Only a limited amount of economic data encompassing the past few weeks has been released so far. Notably, and not unsurprisingly, initial jobless claims for the last three weeks have reached nearly 17 million, with initial jobless claims for April 9 at 6.6 million. The Labor Department has not released unemployment data for the affected period, but there are estimates indicating the unemployment rate will jump to around 10% with further increases expected with the passage of time and so long as “non-essential” businesses are forced to remain closed.
We’ve had many conversations with our clients, and we wish all of you well in these challenging times – we’re all adapting to a “new normal.” The markets are not closed for business. Issuers need to have a complete understanding of the circumstances and work closely with their financing team to establish a plan when preparing to access the capital markets. Flexibility remains paramount, as the market can change dramatically from day-to-day, even if signs of relief are appearing. Additionally, working remotely means putting a work plan in place for the important days within your transaction calendar. Thoughtful planning and strong professional partners should result in achieving your goals as we enter prime construction season.
After a relatively benign start to 2020, we now find ourselves in unprecedented times. In just the last two weeks we’ve seen extraordinary interest rate volatility: Equity markets have declined over 25% from all-time highs, crude oil briefly dipped below $20 a barrel from over $75 as recently as October last year, and weekly jobless claims were a record 6.6 million. The global coronavirus pandemic has brutally shocked every aspect of life. Uncertainty reigns as there is no direct analog that might assist with forecasting outcomes.
The Federal Reserve took emergency actions earlier in March to cut its target range for the fed funds by 150 basis points, leaving the current effective rate at only five basis points (0.05%). The Fed also announced several programs to enhance liquidity in the financial markets as well as unlimited purchases of U.S. Treasuries, agency and mortgage securities. During the week of March 23, the Fed purchased over $600 billion in different assets to support the bond market. Yields for 30-day and 90-day Treasury bills, as well as some Treasury Inflation Protected Securities (TIPS) have gone negative on several days over the past few weeks.
Due to an inverted yield curve, municipal investors saw returns over the past year on cash-like and other overnight investments roughly equal to returns on term securities out to approximately three years. This will no longer be the case for the foreseeable future. While absolute rates are low, there is now a positive slope to the yield curve, with incremental term premium.
Ehlers would like to remind our clients that when markets and rates fluctuate our recommendations may vary based on circumstances, but it is always wise to maintain a balanced portfolio that provides reliable income with the ability to seize on opportunities when they present themselves. Municipal portfolios will need to adapt to a new paradigm and ensure liquidity is available in these uncertain times. We continue to focus on safety of your principal, liquidity needs through asset allocation strategies, and an eye towards a competitive rate of return.
Stay safe and thank you for your continued trust and partnership.
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Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.
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