In Short

• Fixed income markets have withstood historic volatility.
• Wider spreads create value in higher rated bonds.
• A cautious stance on corporate credit is appropriate, but we are more constructive on municipal bonds.

The first quarter of 2020 will be remembered as a historic one: historic in its volatility and historic in the subsequent policy response from lawmakers and the Federal Reserve. As the coronavirus (Covid – 19) swept through the U.S., causing widespread disruption, stock markets plunged and bond markets exhibited volatility and bouts of dysfunction. Uncertainty has been the prominent theme, since it has been incredibly challenging to handicap the length of business disruption, how deadly the virus will be, or how much total business revenue is being lost. In fact, many companies have retracted any earnings guidance for 2020 until they can fully assess the impact. Under this challenging backdrop in March, market participants gravitated to the most certain investment of all:  cash, selling first and asking questions later. The result was a two week stretch where few fixed income sectors were spared from selling.  Bond funds and ETFs facing redemptions indiscriminately sold whatever they could, including highly rated corporate bonds, mortgage-backed securities, municipal bonds, Treasuries, and government agency debentures. The demand for Treasuries is something that the market can usually count on during periods of volatility, but even this was questionable at times.  From March 9^th to March 19^th, the S&P 500 Index declined by 12.2%, and the Ten Year Treasury Yield more than doubled in yield, from 0.54% to 1.14%, a reflection of the fear and dysfunction gripping markets. Since then the Federal Reserve and Congress have intervened quickly and forcefully, enacting programs to help the economy, restore confidence, and improve bond market liquidity. Some 2008 -era support programs are back, some programs are new, and all have their own acronyms, of course. They reach into most corners of the bond market, including commercial paper, asset backed securities, corporate bonds, commercial mortgage back securities, and municipal bonds. Bond markets have plenty of uncertain times ahead, but the scope of stimulus takes some of the worst-cast scenarios off the table. With that view, we are focusing on preserving client capital while simultaneously looking for market dislocations and opportunities that will pay off for years to come.

Source: Statista 2020, IMF

Corporate bonds were right in the middle of March’s volatility. Investment Grade credit spreads, which approximate the market’s view of credit stress, started March at around 125 basis points (1.25%), meaning that on average, yields are 1.25% above a comparable maturity U.S. Treasury. At one point in March, this spread had ballooned to 373 basis points (3.73%) as investors grappled with the virus’s effect on corporate America. High Yield spreads fared much worse with spreads hitting 1100 basis points (11%) on March 23^rd. Some of the spread widening is justified in these unprecedented times as many companies went from profitability to completely shutting down over a two week period. Importantly, much of the weakness was not fundamentally driven but due to deteriorating liquidity conditions.  In volatile times, investors and traders are forced to sell what they can, as opposed to what they want to sell, resulting in good companies trading at fire-sale prices. As one of the only remaining U.S. Triple A rated issuers, Microsoft Corporation’s 2027 maturity bonds started March yielding around 1.65%.  In the midst of the volatility, dramatic spread widening had this same bond yielding a full 1% higher, closer to 2.65%. Funding pressures and volatility have led to the Federal Reserve’s support, with three programs directly intended to help large corporations ease funding stress. The Commercial Paper Funding Facility (CPFF), backstopped by $10 Billion from the U.S. Treasury, lends money directly to issuers in the short term commercial paper markets. Two other programs, the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) will be available to purchase up to $750 Billion in primary market (new issuance) and secondary market corporate bonds. Many companies can survive this crisis on their own, by decreasing discretionary cash flow use and drawing credit lines, but the implemented measures provide for additional piece of mind. Recently, liquidity conditions have improved, credit spreads have tightened, and issuers have been able to tap the new issue market at record volumes. As we move forward into the second quarter, we are paying special attention to companies and sectors that can endure business disruption. An important characteristic of individual bonds is the ability to hold them until maturity, in which case the current volatility will simply be a footnote in history.

Municipal bonds have exhibited some atypical volatility as well. After sixty straight weeks of inflows into municipal bond funds, investors started to withdraw money heading into March. Three subsequent straight weeks in outflows followed, culminating March 11-18^th, when investors withdrew a massive $12.2 Billion. Once again, fund managers and ETFs faced with massive outflows sold whatever they could, sending yields skyrocketing higher. On March 9^th, the ten year AAA muni yield was at 0.81%, and only two weeks later high quality bonds were changing hands at 4% yields. Congress and the Federal Reserve have stepped in admirably to shore up cracks in the municipal market as well. The $500 Billion Municipal Liquidity Facility (MLF) implemented by the Federal Reserve will allow for short term loans to help states, cities, and counties manage the cash flow impact from decreasing tax revenues.  This particular facility focuses its effort on large issuers with eligible borrowers limited to U.S. states, the District of Columbia, U.S. cities with a populations higher than one million, and U.S. counties with populations exceeding two million. The recently passed CARES Act also allows extensive access to emergency loans along with providing outright aid to state and local governments ($150 Billion). In addition, more aid is expected with a “Phase 4” coronavirus package potentially on its way. Municipal issuers get their revenues in different ways. States mostly rely on sales tax, income tax, and funds from the federal government.  Local governments rely on property taxes, and funding from received from their state. While sales and income taxes are expected to be weak, property taxes should be more stable. Many states have also been adding to their rainy days funds during this eleven year bull market, which will help them close budget gaps. In the municipal sector, our strategy has always been to buy high quality General Obligation bonds and revenue bonds backed by essential services (namely water and sewer), which will help insulate our holdings from material credit stress. We still expect municipal bonds to be one of the best fixed income sectors for tax-adjusted, risk-adjusted yield going forward. Within municipal bonds, volatility and higher yields will lead us to be opportunistic buyers.