Liquidity floods the municipal bond market


Municipal bond funds now hold an unprecedented 24% of outstanding debt, down from 16% five years ago, according to Federal Reserve data. The move marks the latest step in a fundamental shift in a buy and hold market where individual investors quietly collect interest year after year.

Record levels of borrowing and investing in 2021 are proof that investors have moved past their early fears that the pandemic could spark a wave of defaults and municipal bankruptcies. Supported by stimulus funds, state and local governments issued $ 302.3 billion in debt for new projects as of December 29, the highest in at least a decade.

Meanwhile, investors invested $ 64 billion in mutual funds and exchange-traded funds through Dec. 15, according to data from Refinitiv Lipper, more than they ever have in the past. this period since the start of monitoring in 1992. That includes $ 22 billion in high yield funds that bleed out of money last year.

“In general, there is a better credit environment, you have a lower offer [and] more demand, and then you just have investors who are willing to take more risk to replace the return they used to get on their high-quality bonds, ”said Eric Friedland, director of municipal bond research at asset manager Lord Abbet.

Bonds issued by state and local governments are especially valuable to investors because they typically bear interest free of federal, and often state, tax. Expectations of possible tax hikes under a Democratic administration have likely whetted investor appetites, Friedland said.

The S&P Municipal Bond Index has a year-to-date total return of 1.76%, including price changes and interest payments through December 30. This compares to minus 2.13% for the S&P US Treasury Bond Index and minus 1.79% for the S&P US Investment Grade A Corporate Bond Index.

Municipal high-yield bonds made more substantial gains as investors let go of their fears of default, with the S&P Municipal Bond High Yield Index showing a return of 6.77% year-to-date through to December 30.

Government and nonprofit borrowers who issue nearly $ 4 trillion in municipal market bonds are generally in a better financial position than they were last year, analysts and reports say financial. Tax collections and stimulus funds have supported municipal balance sheets. The federal infrastructure package promulgated last month could lead to additional funds for capital projects.

The median number of cash days increased 11% this year for 173 nonprofit hospitals that filed their 2021 financial statements, according to Merritt Research Services. For airports that filed returns, the median number of cash days increased 22% and for private colleges and universities a similar cash metric increased 12%.

“These sectors have built up significant cash and reserves that they did not have at the start of the virus in 2020,” said Richard Ciccarone, president and CEO of Merritt. Nonetheless, he said, “not everyone comes back to shape.”

Defects, a rarity in the municipal market, remain higher than during the pre-pandemic period, although they have declined from last year, according to Municipal Market Analytics. Some borrowers have fared particularly badly. There have been 32 defaults to date this year among assisted living borrowers and other senior housing borrowers, the highest number since the company’s record keeping began in 2009.

Some state and local governments also remain on shaky ground, using bond money to fill budget gaps or relying on stimulus funds to cover financial problems. Cities across the United States have resorted to borrowing retirement bonds this year, using a record amount of debt to top up retirement funds in hopes that market returns will exceed interest costs.

Even with borrowings for new projects at a record 10 years, total debt issuance has fallen short of certain expectations. Citigroup has twice downgraded its total emissions forecast for 2021, after Congress refused to include two bond programs in the infrastructure bill. “We were unable to convince our policy makers,” said Vikram Rai, head of municipal strategy at Citigroup.

Including the refinancing deals, municipal borrowers had sold a total of $ 454 billion as of Dec. 21, also a record of at least 10 years.

Cities and states could likely sell about $ 100 billion more in bonds without lowering prices, according to an analysis of lending capacity by Municipal Market Analytics. The supply-demand mismatch widened after the 2017 tax overhaul banned the use of tax-exempt debt for early refinancing while simultaneously making the tax-free return more valuable to some investors by capping the national and local tax deduction.

While municipal bond rates remain at historically low levels, the tax exemption can create significant value in high-income households. A 20-year AA-rated municipal bond had a yield of 1.49% as of Dec. 21, according to Refinitiv Municipal Market Data. For someone in the top tax bracket to get this kind of income on a taxable security, it would have to earn around 2.5%, according to data from asset manager Nuveen.

Investor money flowed primarily through funds, bringing mutual fund and exchange-traded fund holdings to over $ 1,000 billion as of September 30, according to Federal Reserve data.

At the same time, the amount of municipal debt held by brokers and dealers decreased to $ 12.1 billion, a decrease of 26% from 2019. This makes the market increasingly vulnerable to the type of free fall experienced in March 2020, when investors feared how the pandemic could affect municipal credit, which fled the armed bond funds, triggering a liquidity crisis and plunging prices.

“With broker positions declining and mutual funds increasing, there is less of a wastegate,” said Patrick Brett, head of municipal debt capital markets at Citigroup and chairman of the Municipal Securities Rulemaking Board , the self-regulatory body for the municipal bond industry.

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