IMPORTANT NOTICE: Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real-time market developments. All opinions are subject to change without notice.
Month in review
Equities rose modestly in May on signs of economic recovery stemming from the early reopening of cities and states and optimism regarding COVID-19 vaccines in the pipeline. AAA Municipal Market Data (MMD) yields ended May at substantially lower levels than at April month-end. In particular, yields five years and in were down from 70 – 75 basis points (bps) at the end of the month, driving short-term yields close to zero, while yields beyond six years were down between 62 and 65 bps. The 10-year tenor ended the month at 0.84%.1 May total municipal bond issuance of $28.0 billion — approximately $5.3 billion of which was attributable to taxable municipal debt — came in just below April’s final tally of $29.4 billion, marking the second-lowest monthly issuance on the year so far.2
- The Federal Reserve continued to grow its balance sheet in May, most notably expanding its corporate credit facility via the purchase of corporate bond ETFs. The Fed also laid out additional plans for its forthcoming Municipal Lending Facility, a new emergency lending program for state and local government buyers, which it views as a “backstop, not a first stop” for municipal issuers.3
- Municipal bond indices were up in May following the biggest muni rally in a decade. The Bloomberg Barclays Municipal Bond Index returned 3.18% and the Bloomberg Barclays High Yield Municipal Bond Index returned 4.08%, bringing year-to-date total return for the two indices to 1.24% and -6.35%, respectively.4
- Muni/Treasury ratios decreased across the curve in May, most significantly on the short end. Though nearly all tenors of the curve remain above 100%, the one-year ratio ended the month at 65% (down from 476% at the end of April). The two-year ratio ended the month at 100% (down from 479%), the five-year ratio at 127% (down from 321%), the 10-year ratio at 129% (down from 235%), and the 30-year ratio at 116% (down from 180%).5
- Muni/Treasury taxable-equivalent spreads* also decreased across the curve in May. At month-end, spreads equated to two bps at the one-year tenor, 11 bps at the two-year tenor, 34 bps at the five-year tenor, and 77 bps at the 10-year tenor.6
- May’s secondary market trade activity was down for the second straight month in the wake of March’s extraordinarily high levels (the highest monthly figures since 2008). May’s 722,000 total trades marked the median figure for the year to date, though the $234 billion in par traded represented the lowest monthly figure so far on the year.7
Muni technicals in focus: Demand revives in the muni market
As the nation grappled with reopening from COVID-19 lockdowns and widespread unrest prompted by the death of George Floyd, markets showed signs of emergence during the month of May. Equities continued their upward trajectory, with the Dow Jones Industrial Average and the S&P 500 closing the month over 4.5% higher than last month-end.8 Following two straight months of negative returns for the municipal market, the Bloomberg Barclays Municipal Bond Index returned 3.18% and the Bloomberg Barclays High-Yield Municipal Bond Index returned 4.08% in May, the largest monthly gain since September 2009 for both indices.9
After a net ~$16 billion of municipal outflows last month, investors added net $2.87 billion to municipal funds in May, sending municipal yields plunging.10 From its peak of 2.79% in March, the 10-year AAA municipal yield descended to 0.84% this month.11 The rally was more pronounced on the front end of the yield curve, which was bolstered by support from the Federal Reserve.12 Notably, the Federal Reserve released pricing information for the Municipal Liquidity Facility this month, which was generally more favorable relative to market rates for eligible issuers with lower credit ratings.13 Credit spreads continue to widen, spurred by growing demand for high-quality credits. The BBB - AAA 10-year municipal spread has climbed from 61 bps in mid-February to 146 bps at month-end.14
May brought additional data points on states’ revenue outlooks. April tax revenue numbers showed state tax collection declines of over 25% from April 2019, although some income tax revenue is likely to be recouped as taxes are gradually filed.15 Early indications suggest significant declines in sales tax revenue, including Texas and New York reporting that sales tax revenues fell by 13% and 24%, respectively, from April 2019.16 While we expect continued headline risk, we continue to believe states will close the gaps with a variety of measures, including accumulated rainy-day reserves, spending cuts, federal CARES Act funds, and fund sweeps. California dominated attention with its revised May budget, which projects a $54 billion deficit across fiscal years 2020 and 2021. While the numbers are large, we note that the state faced a $60 billion two-year gap during the financial crisis, with far fewer internal tools available to close the deficit. As we approach July 1, we expect many states will opt to pass placeholder budgets until revenue trends become clearer. While some states such as Illinois and California have proposed budgets that rely on additional federal help, we expect these states to find additional budget solutions should federal support fail to materialize.
The end of May saw the outbreak of widespread protests across a variety of U.S. cities. While this may result in temporary increases in police overtime and public safety expenditures at a time when many local governments are already experiencing revenue losses from the pandemic, we do not expect any material impact on the credit quality of high-quality municipal obligors.17 We feel these obligors have the reserves and financial flexibility to manage through near-term stress. The longer-term impact of possible shifts in public safety and social service spending priorities could present difficult decisions for policymakers, but at this time we do not believe it poses credit risk for investors.
To learn more about investing in municipals at PIMCO, please visit pimco.com/munis