ETF Trends caught up with Catherine Stienstra, Head of Municipal Bond Investments, Columbia Threadneedle Investments, to discuss the latest happenings in the muni sector.

What are your current views on the municipal bond market?

Since mid-March nearly 43 million workers, more than a quarter of the U.S. workforce[1], has filed for unemployment. As the scale of the economic damage caused by measures to prevent the spread of COVID-19 unfolds, it is clear that pricing of risk assets will likely be volatile for the foreseeable future.

With state and local governments requiring assistance, and several municipal sectors directly in the crosshairs of the COVID-19 economic fallout, municipal underperformance in March did not come as a surprise. Throughout the month of May, COVID-19 cases continued to trend lower and a greater number of states moved to ease lockdown restrictions. This helped bolster market sentiment across financial markets, and munis were no exception.

The Bloomberg Barclays Municipal Index returned 3.18% in May, significantly outperforming the +0.47% return in the Bloomberg Barclays U.S. Aggregate Bond Index. The Bloomberg Barclays High Yield Municipal Bond Index gained 4.08%.[2]

In terms of our outlook on the muni bond market, we believe opportunities exist in certain sectors that were impacted more by fears of COVID-19 and will be able to bounce back. BBB credit spreads remain wider than historical averages and have been slower to respond during this stabilization period. Barring a second wave of infections shutting down the economy and with improving economic data, there is value in pockets of lower IG credits. We remain cautious on high-yield credit given the uncertainty of COVID-19 and a potential uptick in cases.

We seek to maintain enough risk to benefit from a continued rally in municipal credit while offsetting with longer duration, higher quality holdings. This should provide steady income in a lower-for-longer rate environment.

What are your thoughts on the Fed’s recent intervention to stabilize the municipal market and how do you see this playing out for the remainder of 2020?

Aggressive actions taken by the Federal Reserve in providing stimulus and liquidity to markets, coupled with rapid congressional appropriation of funds to parts of the economy, has provided investors with some level of calm.

On March 20, the Federal Reserve announced that it would extend its asset purchase program into short-term municipal bonds in an effort to enhance liquidity and support state and municipal money markets. As part of its Municipal Lending Facility, the Fed announced in April that it’s buying up to $500 billion worth of state and local government bonds. The facility can now buy investment-grade debt with maturities of three years or less.

Though policy action in March was swift, and continued with additional stimulus in April, relatively little was viewed as directly targeted towards the municipal market. Municipal investors were also unnerved by comments from Senator Mitch McConnell citing his openness to allow states to declare bankruptcy. Injecting this new concern into a skittish market initially prompted a modest selloff, but as the market began to fully appreciate the high legal and political hurdles required, much of that move was recovered by month-end.

Part of the May rally can be attributed to an inflow of cash into muni bond funds due to positive technicals in the near-term, higher taxes on the horizon and congressional stimulus forthcoming.

The House passed the $3T Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act in May and it will most likely be the base for negotiations for the next stimulus package, which we could see as early as July. There’s concern that if state and local governments do not get additional assistance, hundreds of thousands of government employees could face layoffs, resulting in a prolonged recession. As such, we believe that the next round of stimulus will be directed at the muni market in some form.

The Fed updated the municipal liquidity facility (MLF) by expanding the number of eligible issuers and the type of issues that can directly access MLF, which was viewed as an improvement compared to the previous version.

What should investors be thinking about?

During these uncertain times, investors may be tempted to fully de-risk but it’s important to stay focused as markets slowly start to recover. Given the likelihood of a lower-for-longer rate environment, capturing additional income on the long-end of the municipal curve remains prudent. With an uncertain credit outlook, investors need to be comfortable with duration risk as opposed to credit risk at present.

Where are you seeing opportunities?

A cautious primary market and a secondary market still experiencing price discovery should lead towards more attractive relative opportunities. However, we remain hesitant to go far down the quality spectrum until a significant portion of economic activity resumes and are currently favoring higher quality bonds. Though lower quality spreads have widened, current levels may not adequately reflect impending credit stress in the most vulnerable sectors. We expect more downgrades than upgrades, but we are not expecting a significant uptick in defaults.

From a sector perspective, we believe that transportation, specifically airports and tolls, should weather the downturn. While air travel has been at a virtual standstill, most airport operators have solid debt- service coverage, plus an average of 600 days of cash on hand. The Coronavirus Aid, Relief, and Economic Security (CARES) Act passed in March authorizes $10 billion in grants for U.S. airport operators and $50 billion for airlines, which should help stabilize the sector. Many airlines are also reporting an uptick in air travel as we enter the summer months. We also view tolls as attractive given the increase in driving vs. public transportation and families taking longer road trips.

Within health care, hospitals remain attractive though we expect continued headline-driven volatility and downgrades. This stems from increased COVID-19 related expenses and decreased revenue from deferral of elective procedures. However, the CARES Act provides $175 billion in grants for the sector and will allow hospital systems to manage the impact of COVID-19. Our preference is for larger, multi- site hospital providers that should help insulate portfolios.

Historically, markets turn well in advance of improving economic data. We’re closely watching data related to new virus cases that could suggest the worst is over, along with evolving policy responses to help get the economy back on its feet. When investors believe the worst is over, sentiment and prices could rebound quickly.

We have seen strength in the muni market in May and continued strong performance in June. We’re currently at an inflection point. If we see a second wave of cases return, we anticipate a slowdown but the sell-off this time around should be less severe.

How can investors use ETFs to capitalize on those opportunities?

Investors rely on municipal bonds because of their history as high-quality, tax-free assets. But the muni market has shifted and finding income in today’s low rate environment demands a new approach. For instance, most muni bond ETFs track indexes that give the most exposure to the biggest issuers of debt – and even exclude sectors that may offer higher yield, e.g., hospital and housing bonds. A thoughtfully diversified muni allocation with broader exposure and a focus on higher-yielding sectors may deliver greater income potential for investors.

The Columbia Multi-Sector Municipal Income ETF (MUST) is a low-cost investment strategy that aims to take advantage of the inefficiencies in today’s muni market to target more consistent tax-exempt income. MUST seeks to deliver greater revenue potential by including certain exposures to income- generating sectors like transportation and health care, while excluding others. MUST follows a rules- based investment approach, designed by active management, with the goal of targeting higher tax- exempt income and risk-adjusted returns than traditional municipal bond benchmark funds.

[1] Source: Bloomberg News, June 4

[2] Source: Bloomberg, as of 5/31/20. Past performance does not guarantee future results. It is not possible to invest directly in an Index.