The first half of 2020 was dominated by the COVID-19 pandemic, which hit the municipal bond market hard. State and local governments experienced a sharp and sudden drop in revenue, and an increase in expenses, amid stay-at-home orders and business shutdowns.

Looking ahead to the second half, we expect state and municipal budgets to remain under stress, so we favor focusing on higher-rated issuers (AA/Aa) and above for the bulk of an investor’s muni bond holdings. For investors with a higher risk tolerance, a small allocation to lower-rated issuers (A/A) with certain characteristics may be appropriate.

What we expect to see in the second half

Investors likely will be rewarded for staying up in credit quality. A theme that emerged during the first half of the year was volatility due to lack of liquidity. Liquidity is often defined as the ability to sell a security in a reasonable amount of time at a reasonable price. Liquidity in the muni market was strained in March as investors pulled more than $20 billion out of bond mutual funds and exchange-traded funds (ETFs) in a matter of two weeks. To put this in perspective, weekly inflows for mutual funds and ETFs averaged about $1.8 billion in 2019. The substantial outflows caused prices of most municipal bonds to decline and resulted in negative year-to-date total returns, as illustrated in the chart below. The volatility was more severe for lower-rated bonds.

Returns for A-rated-and-above issuers are positive for the year

Source: Bloomberg Barclays Indices, as of 7/6/2020. Past performance is no guarantee of future results.

We think investors will continue to be rewarded by staying up in credit quality during the second half of the year, because higher-rated issuers generally have better resources to manage through the issues caused by the COVID-19 crisis. We don’t expect widespread defaults, but do think that downgrades are likely.

Issuers with already strained finances are most at risk of downgrades. When a bond is downgraded it usually falls in price. If you hold a bond that gets downgraded you should evaluate if it still meets your risk tolerance. We would be more concerned about a bond that is downgraded multiple notches, or to below—or very near below—investment grade.

Federal Reserve actions will continue to help stabilize the market. To counteract the swift decline in muni bond prices, Congress in March passed the CARES Act, which provided direct aid to states and also authorized the Fed to create new facilities to help stabilize markets. The most relevant facility for the muni market is the Municipal Liquidity Facility (MLF). This facility allows the Fed to purchase short-term notes, up to 36 months in maturity, from states, many large cities and counties, and select revenue bond issuers.