Caught in the COVID-19 economic downdraft, the municipal market suffered unprecedented volatility in March. Since then, however, demand for higher-grade municipal bonds has soared, driving the Bloomberg Barclays AAA Municipal Index up 11% between its March 23 low and May 31.

But many mid-grade municipal issues—such as BBB-rated bonds—have lagged this rally, even as other higher-risk assets, such as corporate debt and equities, have enjoyed strong comebacks. Tax-aware investors should sit up and take notice.

For Mid-Grade Credits, Reality Is Better than Perception

To our minds, one ingredient in mid-grade bonds’ lagging performance is perception. The pandemic continues to fuel dire news of state and local budget shortfalls. That leaves most muni investors sour on taking credit risk for now.

As the herd flocked to higher-quality issues, spreads for BBB-rated munis widened 85 basis points, or 139%, from March through May. Even high-yield issues were left in the cold. Their spreads widened 191 basis points—a 101% jump. At these levels, we believe mid-grade credits offer compelling return potential over the next year, based on several spread-tightening scenarios and other factors (Display).

Even if spreads hold steady, such highs encourage active investors to find value by letting research—not fear—lead their decisions. Fear sparks expectations that are almost always dislocated from reality. Active muni investors look beyond perception and at the underlying fundamentals of each credit.

Fundamentals Healthier for Mid-Grade Credits

Many mid-grade issuers are well positioned to weather the pandemic. Even so, a selective, research-driven approach is more important than ever, as fear lingers in some regions and sectors, while normalcy emerges in others.

We’re finding mid-grade opportunities in airports, toll roads and hospitals. These sectors fell out of favor recently, but still have underlying strengths, such as healthy cash reserves and federal support.