DISCUSSION OF FUND PERFORMANCE (Unaudited)
For the period of December 1, 2019 through May 31, 2020, as provided by Daniel Rabasco and Jeffrey Burger, Portfolio Managers
Market and Fund Performance Overview
For the six-month period ended May 31, 2020, BNY Mellon Strategic Municipal Bond Fund, Inc. achieved a total return of -4.62% on a net-asset-value basis.1 Over the same period, the fund provided aggregate income dividends of $0.18 per share, which reflects an annualized distribution rate of 5.02%.2
During the reporting period, municipal bonds were hindered by market turmoil resulting from COVID-19 and the government efforts to contain it. The fund’s performance was driven in part by its asset allocation and security selection decisions.
The Fund’s Investment Approach
The fund seeks to maximize current income exempt from federal income tax to the extent believed by BNY Mellon Investment Adviser, Inc. to be consistent with the preservation of capital. In pursuing this goal, the fund invests at least 80% of its assets in municipal bonds. Under normal market conditions, the weighted average maturity of the fund’s portfolio is expected to exceed 10 years. Under normal market conditions, the fund invests at least 80% of its net assets in municipal bonds considered investment grade or the unrated equivalent as determined by BNY Mellon Investment Adviser, Inc.
The fund also has issued auction-rate preferred stock (ARPS), a percentage of which remains outstanding from its initial public offering, and has invested the proceeds in a manner consistent with its investment objective. This, along with the fund’s participation in secondary, inverse floater structures, has the effect of “leveraging” the portfolio, which can magnify gain and loss potential depending on market conditions.
Over time, many of the fund’s older, higher-yielding bonds have matured or were redeemed by their issuers. We have attempted to replace those bonds with investments consistent with the fund’s investment policies. We have also sought to upgrade the fund with newly issued bonds that, in our opinion, have better structural or income characteristics than existing holdings. When such opportunities arise, we usually look to sell bonds that are close to their optional redemption date or maturity.
COVID-19 Concerns Drove Municipal Bonds
Initially in the reporting period, the municipal bond market benefited from strong demand resulting from concerns about domestic economic growth. Demand was also driven by investors in states with high income-tax rates, who were seeking a way to reduce their federal income-tax liability, which rose when the cap on the federal deductibility of state and local taxes was implemented in the Tax Cuts and Jobs Act of 2017.
Prior to the reporting period, interest-rate reductions by the Federal Reserve (the “Fed”) in August, September and October also helped performance of the municipal bond market. This contributed to a decline in yields across the municipal bond yield curve, though investors largely favored longer-term issues, causing the municipal bond yield curve to flatten.
Performance of the market was also assisted by a manageable supply of new bonds. Supply increased somewhat during the reporting period, as low interest rates led issuers to seek to capture favorable financing.
Later in the reporting period, the emergence of the COVID-19 crisis resulted in turmoil, particularly in March. Fears of widespread economic damage due to COVID-19 caused investors to shift out of the municipal bond market, resulting in large outflows from municipal bond
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DISCUSSION OF FUND PERFORMANCE (Unaudited) (continued)
mutual funds. In a normal market, broker-dealers would step in to buy municipal bonds. But a decline in the municipal bond market, combined with a rally in the Treasury market, prevented them from hedging their municipal bond purchases by shorting Treasuries, as they normally do.
In addition, the municipal bond market was hurt by the inability of large investors to capitalize on the volatility. As municipal bond prices fell, insurance companies and other large investors were expected to step in. Their purchases would normally have been financed by selling some of their corporate bonds, but lack of liquidity in that market hindered their inability to act. As a result, the municipal market yield spreads rose significantly, weakening performance.
But actions by the Fed, including two emergency rate cuts in March 2020 and the implementation of the Municipal Liquidity Facility in April 2020, brought some calm to the market. The liquidity facility provides for the purchase of short-term municipal notes by the Fed, essentially providing a backstop for the market.
May 2020 saw strong rebound in the municipal bond market, particularly among high-quality issues. The market experienced robust inflows from institutional and retail investors, reversing the pattern of the previous two months.
Fundamentals among municipal bond issuers generally were generally healthy prior to the pandemic. Steady but slower economic growth through most of the period had supported tax revenues, fiscal balances and “rainy day” funds. But the economic slowdown due to COVID-19-related shutdowns are likely to weaken the fiscal condition of many issuers.
Asset Allocation and Security Selection Supported Fund Results
The fund’s performance was hindered by its asset allocation and security selection decisions. The fund’s overweight position in revenue bonds was detrimental, as investors moved into general obligation bonds during the COVID-19-related turmoil. In addition, certain market segments underperformed, including charter schools, hospitals, retirement homes, and special tax. As for security selection, the fund’s position in Illinois and Chicago general obligation bonds hindered performance as well. The fund made use of leverage during the reporting period, and this also detracted from performance, as financing rates rose significantly. In addition, the fund implemented a hedge by shorting long-term Treasury yields, and this also detracted from performance.
On the other hand, two factors were beneficial to fund performance. The fund’s relatively long duration contributed positively, as interest rates fell, especially in May 2020, benefiting longer bonds generally. In addition, positions on the shorter portion of the curve were beneficial. Two-year and five-year bonds, in particular, performed well. In addition, to support the fund’s dividend, when yield spreads widened, the fund rebooked yields, swapping current low-yielding securities for higher-yielding securities.
A Constructive Investment Posture
We anticipate that steps taken by the Fed and the government, including the Coronavirus Aid, Relief, and Economic Security (CARES) Act, will benefit the economy and the municipal bond market. It’s also possible that the federal government will implement an additional round of stimulus. In addition, inflation is likely to remain low, and we don’t anticipate higher interest rates in the near future, so we expect to maintain the fund’s longer duration stance in order to capture higher yields. In the near term, seasonal reinvestment of interest and principal payments should also provide some support to the market. Demand for municipal bonds is likely to be buoyed as well by the cap on federal deductibility of state and local taxes.
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We will continue to emphasize sectors that we already own, since these credits are solid, and issuers in these areas have adequate liquidity on their balance sheets. But we will pay close attention to sectors that are likely to be adversely affected in the current environment.
June 15, 2020
1 Total return includes reinvestment of dividends and any capital gains paid, based upon net asset value per share. Past performance is no guarantee of future results. Income may be subject to state and local taxes, and some income may be subject to the federal alternative minimum tax (AMT) for certain investors. Capital gains, if any, are fully taxable. Return figures provided reflect the absorption of certain fund expenses by BNY Mellon Investment Adviser, Inc. pursuant to an undertaking in effect through November 30, 2020, at which time it may be extended, terminated or modified. Had these expenses not been absorbed, the fund’s returns would have been lower.
2 Distribution rate per share is based upon dividends per share paid from net investment income during the period, annualized and divided by the market price per share at the end of the period, adjusted for any capital gain distributions.
Bonds are subject generally to interest-rate, credit, liquidity and market risks, to varying degrees, all of which are more fully described in the fund’s prospectus. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes, and rate increases can cause price declines.
High-yield bonds are subject to increased credit risk and are considered speculative in terms of the issuer’s perceived ability to continue making interest payments on a timely basis and to repay principal upon maturity.
The use of leverage may magnify the fund’s gains or losses. For derivatives with a leveraging component, adverse changes in the value or level of the underlying asset can result in a loss that is much greater than the original investment in the derivative.
Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others. To the extent the fund may overweight its investments in certain countries, companies, industries or market sectors, such positions will increase the fund’s exposure to risk of loss from adverse developments affecting those countries, companies, industries or sectors.
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