Are Municipal-Bonds Always a Safe Haven?

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz from Morningstar. Stocks have slid in recent weeks, but one hard-hit area that has received less attention is the municipal-bond market. Joining me to discuss what's been going on with munis is Beth Foos. She's a senior analyst in Morningstar's manager research group.

Beth, thank you so much for being here.

Beth Foos: Thanks, Christine.

Benz: Beth, let's talk about performance. How munis have performed relative to taxable bonds of similar credit qualities. It seems like their performance has been worse in many cases.

Foos: Well, I think you're right. Munis were extremely strong performers in 2019, and they were still doing relatively well into the early months of 2020. Investors' appetite for muni bonds just soared, and many were willing to take on more credit and interest-rate risk, and demand for yield continued throughout that year. And even into late January, investors were still pouring into muni funds, and muni yields were at their lowest levels in roughly four decades. And then in the past few weeks we've seen that dramatic shift where investors started selling, with increasing concerns around the impact of the coronavirus on the U.S. economy. And that causes prices to tumble, muni yields to spike, and liquidity in the muni market got very tight.

Benz: Let's talk about some of the subcategories in the muni market that have been hard-hit. High-yield munis, I know, have really seen some significant losses.

Foos: Correct. So that's one of the sectors that led the charge, I guess, in 2019. And so far bond funds in Morningstar's high-yield muni category and those that take on more interest-rate risk in our longer categories have also been particularly hit hard in the last several weeks. Managers say they're watching high-yield bonds such as those backed by the airlines, by tobacco revenues and healthcare revenues, both bonds issued by hospitals and continuing-care retirement communities. As well as some of those high project finance bonds, like those that funded convention centers, stadiums, and malls.

Benz: Let's talk about some of the key factors that have been underpinning the recent weakness. I think you hinted at one of the biggies, which was that, coming into this coronavirus-worry period, munis were really priced for perfection. What else is going on there?

Foos: I think there are a few things that are going on. Munis are generally seen as a safe haven for more-volatile investments. And even into February, investors continued to scoop munis up when we saw global equities tumble just a few weeks ago, which caused low muni yields to drop even lower. So, such low yields were likely less attractive for the mostly retail buyers in the muni market and some started to rebalance back to equities. So, we saw some selling there.

But then this was all unfolding at the same time investors were growing concerned about the economic impact of the coronavirus and what that'll do be in the short term and the long term on some muni issuers. And then there's going to be strains on those revenue streams, as we talked about, backed by bonds that are particularly in the transportation sector--as people miss flights or the mass transit systems as they're not going to work. And even more recently, we've seen managers now are reporting that investors are also selling the shorter-term muni debt as they're trying to accumulate cash reserves.

Benz: How should municipal-bond investors respond to this period of volatility? Most of them, as you say, Beth, do look to munis to be kind of their safe-haven funds. How should they react to what we've seen going on?

Foos: Well, munis are traditionally a long dated market, so it really depends on your investment horizon and what you're comfortable with. Of course, it's an incredibly volatile time, and many vested investors are feeling shaken. Because the muni market is so diverse and fragmented, we know it's really important to do solid research, to assess a potential credit interest-rate risk when making your investment decisions in this space. So, when we look to funds that we recommend, we're looking for firms with strong research capabilities, those that have experienced managers and analysts that are using robust tools designed for the sector. We're also looking for stable returns, especially in previous bouts of market stress. And obviously, below-average fees are also important considerations.

Benz: And to the extent that they use some of these high yield or maybe more narrowly focused muni products, maybe they'd want to kind of relegate them to the margins of their portfolios rather than being their centerpiece of their safe assets?

Foos: Right. Again, I think people continued to reach for yield in the past couple of years, and those high-yield funds really did well, but those spreads were really tight. So, that might not want to be the centerpiece of your muni portfolio moving forward.

Benz: This is not the first time we've seen the muni market seize up a bit in periods of volatility. What's the takeaway from that for you and the team in terms of how investors should think about muni products? How can they protect themselves against future periods of duress like this?

Foos: Well, of course, this is an incredibly unique time. It's kind of uncharted territory for all of us. But that said, you're right, this isn't the first turbulent market that munis have seen. We saw munis' yields spike in 2008, again in late 2010, '11, in mid-2013, and after the U.S. presidential election in 2016. They were for a variety of reasons, and they were shorter bouts of stress. But after those, muni markets did see solid performance with strong investment returns, particularly in 2014, in 2017, and 2019.

We've been told managers that have some flexibility to put some money to work here now have reported that the past few weeks have been an incredible buying opportunity for the bonds that they know and they like well. That has tended to be some of those stronger, higher-quality bonds that they've been scooping up. And some of those managers have been scooping them up for several months now, anticipating that the market was pretty rich. They report that, even that said, the higher-quality credits are offering good prices.

Benz: Beth, thank you so much for being here to share your insights today.

Foos: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.