As the novel coronavirus pandemic wreaked havoc on the markets over the past month, municipal bonds initially benefited from the flight to safety that drove Treasury yields lower. But most recently, markets told a different story, as muni yields rose—and prices fell—more than Treasury yields. Investors are now asking: aren’t many municipal bond issuers vulnerable in this crisis?
Muni issuers’ exposure to the battle against COVID-19 varies. Some sectors, such as hospitals, are on the front line. Others, such as state governments, may experience not only first-order effects as budgets stretch to accommodate virus-related expenditures but also the secondary effects of a crisis-induced local or broad-based recession.
So, what steps can muni investors take to protect themselves and earn income as the crisis rages? The most critical step is to stay active. Passive laddered strategies have no ability to maneuver through the crisis, nor can they efficiently rotate into higher-yielding issues as rates climb. In contrast, active and flexible strategies can help muni investors better respond to the risks—and opportunities—that emerge in challenging environments like this one.
Municipal Yields Sharply Higher
One outcome of recent market activity has been the significantly increased attractiveness of municipal bond yields after taxes, relative to Treasuries.
US Treasury yields saw an unprecedented decline in the past few weeks, with the yield on the 10-year note plunging to a record low of 0.32% at one point on March 9. It’s since made its way back to around 1.0% but remains well below the 1.9% level where it began the quarter.
In contrast, municipal bond yields have risen, with 10-year yields now at 1.7%, compared to 1.4% at the start of the year. The ratio of municipal yields over Treasury yields—a measure of the relative attractiveness of municipals—is now around 400% for one-year securities and nearly 200% for intermediate-maturity and long bonds. A municipal/Treasury ratio above 100% indicates investors should strongly favor municipal bonds over Treasuries.
Investors who had the flexibility to allocate part of their muni portfolios to one- and 10-year US Treasuries, as we suggested in January, should pay heed to that relationship. Now that the after-tax yield relationship between municipals and Treasuries has flipped, we think it’s time to rotate those short-maturity Treasury holdings back into munis.