Market Commentary: Reluctant Superhero

In its 106-year history, the Federal Reserve has never bought a municipal bond. Its sixteen governors, chairmen and women never wanted to. Never had to. Never agreed to. Until SARS-CoV-2 (the virus) and COVID-19 (the novel coronavirus disease) arrived on our shores and began ravaging our communities and devastating our economy. The central bank’s focus has long been on buying and selling Treasuries to regulate the flow of money and credit. Since 2008, its open market operations have expanded to include agency debt and agency mortgage-backed securities. Recently, its quantitative easing efforts have been further extended to certain corporate and municipal bonds and ETFs and, at this writing, the Fed balance sheet totals $6.72 trillion and counting.

All too often, central bankers have faced accusations of being in cahoots with presidents to make the economy look good during election years. The last thing they ever wanted or needed was to get embroiled in local politics, how to price the bonds of Boston versus those of San Francisco, or whether to bail out New York City or Anchorage. During the last recession, even in the face of urgent pleas, former Chair Ben Bernanke flatly refused to get involved with this $3.8 trillion market. Twelve years later, the Fed found itself in the middle of some swirling market madness and, with prodding from big banks and broker-dealers and key committees in Congress, quickly acted in a way that a president or Congress could not do. In the last eight weeks, it set aside more than a century of precedent and used its limited authority to add munis as eligible collateral for secure loans, and expand the scope of its facilities to include municipal commercial paper, short-term municipal securities and variable rate demand obligations. As 30-year benchmark tax-exempt yields jumped from 1.52% at the end of February to 3.37% by March 23, weekly rates rose from 1.15% to 5.20% as a result of record-setting levels of redemptions in municipal bond mutual funds. The yields reflected pressure on the liquidity of assets long seen as second only to the $16.7 trillion government market in terms of safety and stability — the main difference being that there are more than 50,000 different muni credits, some rated, some not, instead of the one global benchmark U.S. Treasury.

With the Fed’s interventions, it did not take long for things to calm down. Today, the SIFMA rate is at 0.19%, a four-year low. It was like nothing ever happened. The Fed erased all the fear and uncertainty on the short end. The longer end of the market is another story. Dealer inventories are at multi-year lows and many firms are hesitant to commit capital. The new issue market, which had been going gangbusters for years, came to an abrupt halt in March and is still not back. Fear of the unknown has gripped much of the traditional investment community. Lack of disclosure on the part of some borrowers plus the inability to project the extent of the damage and timing of the recovery has challenged many rational folks. Some have moved to cash and lost valuable income. Others have pounced on risky stocks just because they have dropped from vastly overpriced to highly overpriced. Yet more are diving into sub-investment grade corporate bonds, perhaps under the misconception that the Fed’s superpowers will fend off default or bankruptcy.

Sensible investors, looking at the landscape, assessing the truly fundamental underpinnings of our local economies, are finding that temporary revenue declines in the municipal context are significantly different from profits forever lost on the corporate side. They are seeing lasting value and steady income in tax-exempt and taxable municipal bonds: in children’s hospitals, community colleges and trade schools, well-managed nursing homes and memory care facilities, turnpikes used by the truckers delivering essential goods cross-country, residential and commercial water and sewage projects, power authorities, large seaports and airports, and federally subsidized housing. These are all essential to the functioning of our communities and are simply not as vulnerable as stadiums, casinos, hotels, malls, poorly positioned colleges and airlines, autos and rental cars, or cruise economic downturns or black swan events. Black swans such as this pandemic, are extremely rare, unpredictable events, with a severe impact, well beyond what is normally expected in a given situation such as an economy in the longest expansion on record with the lowest unemployment rate in 50 years.

Some muni deals have been in the pipeline for two months now for lack of buyer interest. But some highly rated issues and national names plus a host of municipal utilities have successfully priced deals at what are still historically low rates for them and at good prices for some buyers. Many of these borrowers have solid financials with deep and diverse bases of revenue or they have the market’s confidence that the federal, state and local governments will provide the necessary plugs for any future shortfalls. Mesquite, Texas, a city of 145,030, issued $14 million of AA rated general obligation bonds due in 10 years at 5.00% to yield 1.97%. The New York Metropolitan Transportation Authority, whose subways transport more than 5.4 million of people on an average day and are one of the most essential public services in the City That Never Sleeps, just sold $1.1 billion of 25-year term bonds at 5.25% to yield 5.23%.

There is no doubt that states and cities across the country have taken a wallop from the economic impact of policies ordering the majority of its citizens to remain at home for months. Revenue from sales and income taxes has dropped while a host of pandemic-related expenses has decimated coffers including rainy day funds. The Fed, now the superpower of the U.S. if not the world, is fleshing out the details of an emergency program, called the municipal liquidity facility, which enables it to issue up to $500 billion in short-term municipal recourse general purpose loans to states, and to cities and counties of a certain size. The vast majority of communities (as well as conduits such as transit, housing, health care and higher education agencies) would have to go through their states and all borrowers would be limited to amounts up to 20% of certain 2017 revenues. Borrowing rates include a fee and will hinge on the credit rating of the state or local government. The loan will have to be either refinanced or repaid, and the hope is that all will paid back within two years once the economy recovers. But funds will be made available at higher rates than are generally available in the market and will largely be limited to those who are not able to access the markets at something close to benchmark rates.

The Fed plans to cut and run from these emergency programs as soon as they are no longer needed and the economy is clearly in recovery. The muni program and other emergency facilities are intended to be very short-term, expiring in December unless there is need to extend them. They will not be able to help every state, municipality, and company. But the capital markets are buoyed by this central bank support. New issues are on tap for Duke Energy, Duke University, UnitedHealth, and Children’s Hospital in Omaha, for example. Yes, there will be more federal aid. And yes, there will be defaults and bankruptcies concentrated in a very small percentage of these bond markets. We encourage you to contact your HJ Sims advisor to help you identify tax-exempt and taxable bonds that have essential public purposes and serve consumers in key sectors including senior care, health care, education, water, transportation, and technology that provide steady streams of income to match your short- and long-term needs. At this writing, the 10-year Treasury yields 0.64%, 10-year Fannie Maes yield 1.17%, the 10-year BAA rated tax-exempt municipal general obligation bonds yield 2.34%, the 10-year BAA rated taxable muni yields 3.22%, and 10-year BAA rated corporate bonds yield 4.23%.

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