Tax-Free High Yield Fund (Class Y)  (PTFYX)

Municipal bonds posted positive performance in January and February, supported by stabilizing U.S. economic fundamentals and positive supply/demand technicals. However, in late February, fears about the spread of the coronavirus and its potential impact on global economic growth sparked a steep sell-off in equities and other high risk assets. After experiencing the largest inflow year in 2019, municipal bond funds began to see outflows in March, particularly in the lowest tiers of the market. [Fund flows are a measure of investor demand for mutual funds.] The heavy selling led to the worst month of performance [-3.63%] for the asset class in decades. The Bloomberg Barclays Municipal Bond Index [the benchmark] closed the quarter with a decline of -0.63%. In comparison, the ICE BofA U.S. Treasury Bill Index and the Bloomberg Barclays U.S. Aggregate Bond Index rose 0.65% and 3.15%, respectively.

Credit spreads widened significantly, particularly among lower-quality, high-yield municipals led by airline/airport and tobacco bonds. In the rush to safety, even general obligation bonds of highly rated issuers such as the State of California sold off. The outflows depressed prices, and yields rose. In turn, the municipal bond market saw a dislocation in the municipal and U.S. Treasury yield relationship, referred to as the Municipal/Treasury [M/T] ratio. The M/T ratio measures the yield on AAA-rated municipal bonds relative to the yield on U.S. Treasury yields of similar maturities. The higher, or cheaper, the ratio, the more attractive municipal bonds are relative to U.S. Treasuries. Given the sell-off, municipal bonds were yielding more than 100% of Treasury yields. Historically, a ratio in excess of 100% is interpreted as a buy signal and suggests an attractive entry point for long-term investors.

With the health risks posed by the pandemic rising and economic and financial market conditions deteriorating, monetary and fiscal policy makers moved into action. The Federal Reserve lowered interest rates to near zero and increased asset purchases to help ease tight credit markets. In an especially noteworthy move, the Fed announce on March 23 that they will start buying corporate and municipal debt. This allows cash-strapped states and cities to get loans to tie them over until the U.S. economy bounces back. On March 27, Congress finalized a $2.2 trillion relief package, the largest in history, to help hard-hit industries and provide relief for families, small business, and hospitals and health-care systems.

We believe state and local governments can benefit from their unique flexibility during economic crises. The majority of state and local governments have ample reserves in preparation for potential revenue declines, and those without strong reserve levels will have some flexibility to balance their budgets using one-time measures. Governmental entity defaults remain extremely rare despite headlines suggesting otherwise. Our exposure to state and local governments is limited to credits with diverse tax bases and the ability to enact broad revenue enhancements or expense cuts.

In our view, state governments are among the safest credits in the municipal market, benefiting from broad sovereign powers over revenue generation and spending. While the temporary freeze in commerce and related job losses will result in a decline in income tax and sales tax revenues for most states, and measures to combat the pandemic will lead to additional one-time spending, we believe state governments will manage this period through the use of reserves, federal aid, short-term borrowing, and additional revenue measures as needed.

Local governments generate most of their revenues through property taxes, which tend to lag economic activity by one to two years and should continue to see solid revenue collections for the next several quarters as a result. As with states, the pandemic containment effort will result in some one-time spending. A decline in state revenues will result in fewer grants trickling down to the local level, though we expect this disruption to be temporary. In our view, most states and local governments would only see prolonged fiscal stress should economic activity fail to stabilize over the next 12–18 months.

Municipal bonds are a very highly rated sector. Historically, defaults represented a very small portion of the overall municipal bond market and were typically found in the lowest rated or non-rated cohorts. According to Municipal Market Analytics, defaults represented 0.09% of the overall market in 2019.

That said, we are in uncharted waters and credit fundamentals are deteriorating. As such, defaults are likely to increase relative to 2019’s low base. However, we expect the absolute number and market value of municipal bond defaults to be very low relative to the broader fixed-income markets.

High-yield municipals represent a small subset [5%–10%] of the overall municipal bond universe. At this point, while we don’t expect widespread defaults in the market, some sectors could be hit harder than others. Small colleges, dorm financing, and weaker names in health care and transportation come to mind. As such, we have become select sellers of lower-rated bonds in sectors that we believe could be more challenged and possibly see an uptick in defaults over the next 12 to 24 months. This includes certain colleges and universities, project finance, retirement communities, and land development sectors.

In Putnam Tax-Free High Yield Fund, approximately 60% of the portfolio’s investments are rated investment grade. We have been more cautious on the lowest quality tiers of the market as we believe slowing U.S. economic growth could manifest itself in more challenging credit conditions in some of the lower-rated cohorts. We continue to believe our higher-in-credit-quality approach can add both income and return opportunities for our shareholders.

In our broader municipal portfolios, we continue to favor bonds rated above high-yield tiers. This is due to spread compressions in the market prior to the sell-off and some degradation in credit quality. This resulted from some borrowers not meeting our credits standards, in part because of fewer security features and covenants, among other reasons.

With regard to the effects of the pandemic on the U.S. economy, it is too early to know the magnitude of the shock or how deep or long any recession will be. Given the uncertainty, we have become more cautious in our municipal fundamental outlook. In addition to selling lower-rated bonds facing challenges, we are carrying 3% to 5% of assets in cash versus a 2% level that is typical of more stable times.

In our view, safe-harbor sectors include school districts and utilities. School districts benefit from a constitutional mandate to receive adequate revenues from state governments and often have the ability to levy property taxes similar to local governments. Water, sewer, and public power utilities should also remain resilient during the crisis as they provide essential services and most borrowers benefit from the ability to raise rates if needed. While we may see a moderate increase in payment delinquencies, we do not expect any of these sectors to encounter a significant spike in defaults.

We’ll continue to work closely with our macroeconomic team and our taxable corporate credit analysts to monitor the direction of U.S. economic activity and its potential impact on municipal credit fundamentals. We believe that the majority of municipal bonds continue to offer a high-quality, low-default asset with an attractive after-tax yield.