As the reopening trade gathers full steam, for some muni investors, last year’s underperformers are turning into today’s gems. This is driven by renewed sense of optimism as the economy reopens after being shuttered during the pandemic. Even sectors most impacted by last year’s shutdown are seeing strong investor demand. With investors regaining their appetite for risk, fund flows into high yield munis are soaring this year. As credit spreads continue to shrink, are investor’s stretching for yield again?
- Investors are regaining their appetite for risk as the economy reopens after being shuttered during the pandemic.
- Record muni fund flows year-to-date especially in high yield are leading to continued spread compression for lower quality bonds.
- Muni sectors hardest hit by the pandemic are seeing strong investor demand.
Money is flowing into the muni asset class at a record clip this year. Possibly, this is due to expectations of higher income taxes in the future. For those investors facing potentially higher income tax rates, the value of the tax-exempt income provided by many municipal bonds increases.
According to the Lipper U.S. Fund Flows database, year-to-date through April 21 flows totaled $23.9bn, the largest on record for this time of the year. This compares to neg. $12.9bn for the same time last year. Particularly strong are inflows into high yield munis with year-to-date inflows of $7.7bn.
During the week of 4/14, inflows into high yield totalled $1.3bn, the highest weekly total on record. Furthermore, four of the largest weekly inflows on record for muni high yield occurred this year.
Exhibit 1. Muni High Yield Fund Flows Sets All-time Weekly Record in April
As investors continue to pour money into securities with higher credit risk, BBB credit spreads are now approaching pre-COVID levels. Year-to-date through 4/20/21, BBB credit spreads tightened 37 basis points.
Exhibit 2. BBB Spreads Continue to Decline, Now Approaching Pre-COVID Levels
Different Situations, Similar Risk Appetite
In the current environment, some of the muni sectors hardest hit by the pandemic – retail developments, student housing, and hospitality sectors – are seeing solid investor demand.
This is occurring despite ongoing challenges in ramping up business activity back to pre-pandemic levels.
For example, Ballston Quarter, a retail development located in Arlington, Virginia, was impacted by reduced customer traffic and sales activity last year.
As shoppers stayed home or opted to shop online, brick-and-mortar retail projects, such as Ballston Quarter, have struggled. The development, which includes over 350,000 sq ft of retail space, is currently only 70% leased compared to original projections of reaching 100% leased by end of 2019.
Slower lease-up combined with reduced foot-traffic are impacting sales tax collections, which are used to repay the bonds issued to finance the development.
Student housing developments were also hit hard last year as most dormitories sat empty due to remote learning protocols.
This severely impacted debt issued to finance college dorms such as Bayview Student Living at Florida International University (owned by NCCD – Biscayne Properties LLC).
Due to the pandemic, occupancy rates dropped from around 96% pre-pandemic to 48% currently, a level below what is needed to support the borrower’s annual debt service requirements. The university has announced plans to return to fully in-person learning this summer in addition to hybrid and on-line options.
Finally, as business travel came to a halt, convention centers and hotels were essentially shut down during the height of last year’s pandemic.
While many have started to reopen, the recovery has been more gradual. Bonds were issued to fund the Sheraton Overland Park Convention Center Hotel, a 412-hotel serving the city’s adjacent convention centre.
Since the convention center re-opened in July, it’s only bringing in about 10% of the business that it would normally see.[1] Occupancy rates at the hotel, which rely on convention center business, have dropped directly impacting tax receipts securing the bonds.
What’s common among Ballston, Bayview, and Sheraton Overland? All three projects did not generate sufficient cash flow to cover their most recent debt payments.
Instead they are relying on tapping their debt service reserves to fund payments to bondholders. A draw on the debt service reserve fund is generally a sign of fiscal distress and would typically prompt a deep discount in the bond’s value by market participants.
However, in the current market environment, institutional investors are aggressively bidding the bonds, with recent market color for bonds issued on behalf of all three projects closer to par.
It certainly appears as if some investors see an opportunity as business activity ramps-up following last year’s shutdown.
Is this optimism well founded? Are we headed to a swift return to a pre-pandemic economy or is the market underpricing credit risk? Only time will tell if the “back-to-normal” trade proves to be a winning strategy.
Given where spreads are today, current market views could shift rapidly if the effects of COVID-19 prove more lasting. We remain vigilant in this shifting landscape on how these dynamics play out in the current market environment and their impact on muni bond valuations.
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