Rising interest rates are threatening the municipal-bond boom on Wall Street, leaving governments less willing to borrow and households less willing to invest in the $4 trillion market.
Bond issuance by state and local governments dropped 8% in the first quarter from a year earlier, with public officials calling off refinancings and spending down stimulus cash. At the same time, spooked investors yanked their money from municipal-bond funds, which suffered their biggest quarterly outflows since 2013.
States and cities have been forced to cut prices to sell their bonds to banks and insurance companies because muni bond funds are no longer offering top dollar, dealers said.
“2021 was a market where everybody wanted to buy because there was so much inflow and so much cash," said Chris Lee, head of municipal sales at Wells Fargo & Co., the fourth-largest muni-bond broker-dealer by volume last quarter. “This year it’s much more of a negotiation."
Bonds from corporates to Treasurys suffered their worst start to the year in decades, ahead of Federal Reserve moves to rein in inflation. After increasing interest rates by a quarter-percentage-point last month, the central bank could raise rates by a half-percentage point in May and begin reducing its $9 trillion asset portfolio, the Fed’s latest policy-meeting minutes suggest.
Benchmark yields on triple-A, 10-year, tax-exempt general-obligation muni bonds were 2.34% on Friday, compared with 1.03% a year earlier, according to Refinitiv Municipal Market Data. For investors in the top tax bracket, that equates to a taxable yield of around 4%, according to data from Nuveen Asset Management.
“Definitely it’s been a damper on refinancing," said RBC Capital Markets municipal syndicate desk managing director Glenn McGowan, who works with state and local governments selling bonds.
Municipalities borrowed a combined total of about $97 billion in the first quarter, slipping below $100 billion for the first time since early 2020. Refinancing activity fell by nearly half, to $21 billion. For the past two years, state and local governments have executed about $40 billion in refinancing deals in the first quarter, as public officials took advantage of low rates and put off debt payments to manage a Covid-19 budget squeeze.
Now some governments are relying less on borrowing for budget management after collecting record tax revenue from the stimulus-fueled economic boom, as well as direct federal aid.
Covid-19 aid from the federal government freed up room in Chicago’s budget to make coming bond payments, allowing the city to cancel a plan to cover the payments with new debt, according to budget documents. New Jersey, flush with revenue from a banner year last year, is planning to pay up front for $1.2 billion of capital projects rather than borrowing at rising rates, the state treasurer’s office said.
Borrowing for new projects remains strong even as refinancing has dropped. But it can’t be determined when demand will catch up with that supply. Investors who are tired of watching their mutual-fund shares sink in value pulled money from municipal-bond funds for the eighth consecutive week during the period ended Wednesday, according to Refinitiv Lipper. The prospect of new borrowing at higher rates makes outstanding, lower-coupon debt less attractive.
Municipal bonds have the benefit of paying interest that is exempt from federal and often state income taxes. They have posted negative returns so far this year but haven’t performed as poorly as some other fixed-income assets. They have returned minus 6.89%, compared with minus 7% for Treasurys and minus 9.31% for corporate bonds as of Thursday, according to Bloomberg indexes.
Still, of 130 analysts polled by dealer HilltopSecurities in March, 44% expect municipal bond fund flows to be negative in 2022. An additional 27% expect net inflows to be less than $25 billion. Inflows last year were $66.5 billion.
An exodus of municipal bond fund investors can have a major impact on bond prices because mutual funds hold about 23% of outstanding debt, according to Fed data. Prices tanked when investors withdrew more than $30 billion in six weeks in the early days of the Covid-19 pandemic, but the panic was short-lived. Muni-bond funds suffered a net $10.8 billion in outflows in the first quarter of 2020 and ended the year with inflows of $22.2 billion.
Net outflows in 2022’s first quarter were $14.9 billion.
“Even in the worst Covid year, outflows were still a real net positive," said Tom Kozlik, head of municipal research and analytics at HilltopSecurities.
The last time yearly municipal bond fund flows were negative was in 2013. Back then, investors were fretting over deteriorating finances in Detroit and Puerto Rico and bracing for the Fed to start dialing back the easy-money policies that had supported credit markets since the 2008-09 financial crisis.
This year’s falling prices have attracted some buy-and-hold investors. Bondholders who own munis until maturity, collecting interest payments along the way, don’t have to worry that they will end up cashing out at an unappealing price driven down by market movements.
Investment adviser Edward Mahaffy of Little Rock, Ark.-based ClientFirst Wealth Management, said he has been buying high-grade bonds maturing in three to four years for his clients.“I have been waiting for an opportunity like the one we are now experiencing," Mr. Mahaffy said.
