While Treasurys prices have been consolidating after a massive run higher over the last year, experts are concerned about how municipal bonds and consequently muni bond ETFs may fare in the wake of a newly burgeoning coronavirus pandemic in the U.S.
The effects of the coronavirus pandemic have disseminated widely, causing nearly 125,000 deaths from roughly 2.5 million cases in the U.S. This has led to significant disruptions to the global economy and the loss, however briefly, of approximately 40 million jobs, which could reassert itself given there is a second wave.
With the next wave possibly about to hit, and an increasing number of reports of new infections in Florida, Texas, California and Arizona over the last week, this could all lead to shutdowns, layoffs, and business bankruptcies that will propel a steep drop in tax revenues for state and local governments, slamming their budgets deep into the red. That is likely to cause a sharp decline to government payrolls, leading to potentially higher taxes and cuts in essential services.
It also could mean big changes in the quality of life of thriving urban centers, which affects municipal bonds, which have done exceptionally well in recent years and have become particularly attractive to middle- and upper-middle-class people in high-tax states, making the munis a far less desirable investment.
Municipal bonds, also known simply as munis, are debt obligations issued by government entities. Like other forms of debt, when you purchase a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period of time. At the end of that period, the bond reaches its maturity date, and the full amount of your original investment is returned to the investor.
The loss in tax revenues may be much larger than projected. A new study by Christos Makridis, a research assistant professor at Arizona State University and a Digital Fellow at MIT Sloan School of Management, and Robert McNab, a professor at Old Dominion University, estimates total decreases in state tax revenues to be $289.4 billion, measured in 2019 dollars. That represents an average of a 20% drop in state tax revenues, which could clearly affect municipal bonds.
All of this is something that municipal bond investors should be vigilant about. The iShares National Muni Bond ETF (MUB), which outperformed the Vanguard Total Bond Market ETF (BND) since 2017, has flagged since coronavirus hit, with a total return of roughly 1.9% in the year to date, versus a 5.9% total return for the Vanguard Total Bond Market ETF.
There could be some good news for muni bond holders and municipal bond ETF holders.
David Mann, Head of Capital Markets, Global ETFs, Franklin Templeton, argued that following the Fed’s announcement of purchasing corporate debt through its Secondary Market Corporate Credit Facility, the central bank could even begin to purchase smaller ETFs as it moves to the next phase of owning individual bonds.
Specifically, Mann believed that the Fed could move on to smaller fixed income corporate bond ETFs with lower average volumes where almost every dollar invested in those ETFs would be similar to a dollar invested in the underlying bond markets.
“The purchases we have seen thus far into the largest ETFs allowed broad exposure to the corporate bond market, but they did not necessarily lead to individual bond buying because of all that on-exchange volume,” Mann said. “Now, these smaller ETFs could be used as an explicit conduit for buying individual bonds which is consistent with the aim of the SMCCF.”
Other financial experts also see a potential bright spot for muni bonds.
“During periods of economic uncertainty, near-term decisions can determine the nature and durability of the recovery that drives long-term credit quality,” said VanEck portfolio manager Jim Colby in a recent note. “I believe there is some cause for optimism for recovery in the municipal bond market. There may be many bumps in the road, but fears of many Humpty-dumpty defaults really belong more in a story about Chicken Little.”
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