As the 2021 fiscal year officially gets underway for many municipal issuers, state and local governments have begun to take stock of the economic toll of COVID-19.
So far, the results aren’t pretty.
Some states are predicting shortfalls ranging from 10%-20% of their annual budgets, which have already paved the way for painful fiscal austerity measures. And with many states dialing back economic reopening plans, the economic pain will likely be felt for some time to come.
An unprecedented policy response
Fortunately, the U.S. Federal Reserve has stepped in with an unprecedented policy response. In order to enhance market liquidity, the Fed is extending credit to new corners of the capital markets, including municipal bonds. While the Fed’s actions have helped restore confidence in the municipal markets, investors must now contend with the effects these policy responses are having on market dynamics.
Fed lending facilities expand to include munis
With backing from Congress and approval by the U.S. Treasury, the Federal Reserve Board in March reincarnated a number of lending facilities created during the 2008 financial crisis, while also creating an entirely new mechanism for enhancing municipal market liquidity.
- The Primary Dealer Credit Facility (PDCF) provides term loans to primary dealers in order to facilitate smooth market functioning. Unlike the last PDCF, which operated between 2008 and 2010 and consisted solely of overnight loans, the latest iteration offers funding for up to 90 days.
- The Commercial Paper Funding Facility (CPFF) allows the Fed to purchase municipal issues with maturities ranging from one week to 270 days. The aim of the CPFF, which also had a previous life in the throes of the 2008-2009 recession, is to enhance the liquidity of the short-term lending market by providing a backstop to issuers of commercial paper.
- The Municipal Liquidity Facility (MLF) was newly established in March to lend up to $500 billion directly to eligible municipal issuers, with maturities of up to 36 months. These include investment grade-rated states, cities with more than 250,000 residents, and counties with populations of more than 500,000 residents. More recently, the Fed expanded issuer eligibility to include two revenue bond entities per state, which opens the door to public transit agencies such as the New York Metropolitan Transportation Authority.
While these Fed facilities have been effective in bringing down short-term yields and improving market sentiment, they could also affect how investors deploy their capital.
For municipal investors, we see a number of key takeaways for the balance of 2020:
- Steeper yield curves. All of the Fed’s focus thus far has been on short-term maturities of fewer than 36 months. However, the municipal bond market has an average maturity of approximately 12 years, and many issuers prefer to issue 30-year fixed rate bonds. This could create opportunities for investors to earn additional return by purchasing longer-dated municipal bonds. Following a protracted flattening trend, the spread between two- and 30-year AA-rated municipal bond yields has increased from roughly 90 basis points (bps) to 150 bps since the announcement of the Fed’s credit facilities. With economic recovery likely to be sluggish and short-term interest rates expected to be near 0% for at least a few years, we see value in longer maturities between 15 and 20 years.
- Little evidence of stigma for issuers that rely on Fed funding. Some market participants have expressed concern that municipal issuers electing to tap the MLF may face a stigma, which could result in higher borrowing rates down the road. So far we’ve seen little evidence of this. To the contrary, issuers using the MLF are achieving a lower cost of capital and reducing public market supply, which has led to tighter spreads on outstanding debt.
This trend can be seen in Figure 1, which shows the yield compression of three-year State of Illinois bonds since the MLF pricing was released. Illinois is thus far the only municipal issuer to use the MLF, although others may eventually follow.
- The MLF is expensive, which could limit its use. At current levels, public market yields are 100-200 bps below MLF borrowing rates. For that reason, we expect most issuers will rely on the public markets to bridge large cash flow deficits for the time being. In the meantime, many state and local governments are waiting on Phase 4 stimulus details to emerge from Congress, which could include up to $300 billion in additional aid to state and local governments. Once the extent of fiscal support is known, we expect increased issuance of short-term (1-2 years) notes, which could push short-term tax-exempt municipal yields higher.
- Default risk is increasing among some lower-rated munis. The municipal market comprises nearly 50,000 issuers, and only a small fraction of them will receive direct support from the MLF. For lower-rated portions of the high yield municipal market, a prolonged economic recovery and changing mobility patterns pose an existential threat. These include assisted living centers, sales tax bonds with large exposures to retail shopping centers, speculative grade transportation projects, and convention center-related debt, to name just a few.
Credit quality still matters
For investors, the watchword is caution. Those tempted to chase the lowest-quality portions of the municipal market in search of higher yields should remain vigilant. Monetary policy support alone will not be enough to prevent high yield defaults and permanent capital loss in many of these securities. While the Fed’s policy response has breathed much-needed liquidity into the municipal markets, it is far from a panacea.
Visit Municipal Bonds at PIMCO for more on how we help investors unlock the potential of munis.
For more on how the COVID-19 pandemic is affecting municipal markets, please read, “Are Municipal Defaults on the Horizon? Probably Not”.
David Hammer is head of PIMCO’s municipal bond portfolio management, and Rachel Betton is a municipal bond portfolio manager.