(Image: Shutterstock)

The economic downturn caused by the coronavirus pandemic is creating havoc in one of the sleepiest sectors of the bond market: municipal bonds.

The muni market has experienced unprecedented swings in yields and prices because of the growing economic impact of Covid-19 on states and localities, who are at the front lines fighting the pandemic. While healthcare costs are growing, sometimes exponentially, state and local revenues are falling because of businesses closing or operating at a fraction of their usual capacity.

"There has been more volatility in the last three weeks than the muni market has ever seen," said Matt Fabian, a partner at Municipal Market Analytics, an independent research firm.

Chris Brigati, head of municipal trading at Advisors Asset Management, said he's "been concerned about some event that would create a liquidity challenge to the muni market at some point, and now we've found it."

The liquidity challenge in the muni market was evident in trading from mid to late March, when the spread between the AAA-rated long-term muni bond index and 10-year Treasuries swelled to over 200 basis points (bps) in the span of about two weeks. Massive redemptions by muni bond mutual funds were a major catalyst. Nuveen reportedly tried to unload $700 million worth of munis in one day.

The muni-Treasury spread subsequently narrowed to about 65 bps after the Federal Reserve announced a backstop for state and local governments, adding short-term muni debt as collateral to a lending facility for money market funds, and Congress approved a $2.2 trillion emergency economic package. The package includes about $150 billion in direct aid to state and local governments, $274 billion for Covid-19 response efforts, and less than $40 billion in block grants and school and child care funding.

No money was allocated for states to close their budget gaps, which are growing because of falling tax revenues and increased costs for healthcare and other services. The Treasury's three-month delay in the federal tax filing deadline will also postpone payments of state and local taxes.

State and local governments "are likely to have huge budgetary stresses that the fiscal package did not address," said Louise Sheiner, a senior fellow at the Brookings Institution, in a recent webinar on the economic impact of the Covid-19 pandemic. "It's important that state and local governments get some aid, because otherwise they will be one factor—as they were in the past Great Recession—for holding back the recovery."

Most state and local governments, unlike the federal government, need to balance their budgets annually and cannot issue debt to fund ongoing operations, also known as deficit spending. But they can use some gimmicks to give them some breathing room, as Governor Phil Murphy of New Jersey recently did by moving the beginning of the state's next fiscal year from July 1 to October 1.

More help for state and local governments, including elimination of the cap on state and local tax deductions, is under consideration by House Speaker Nancy Pelosi, D-Calif., for the next Covid-19 stimulus package, but it is uncertain when the next phase—the fourth phase—of federal stimulus will be forthcoming.

"We now have a market blooming with credit risk," said Fabian of the municipal bond market. "That doesn't mean we're going to have a lot of defaults, but a lot of credit pressure. Pricing is also a problem. … There are some 40,000 credits in the muni market, and disclosure is not current for many of them."

With that in mind, the Municipal Securities Rulemaking Board began publishing on Thursday a weekly summary of disclosures submitted to the EMMA system by issuers of municipal securities that reference Covid-19 to "to assist market participants, policymakers, and the general public."

Despite problems in the muni market, Fabian said, there are "opportunities out there to buy high-grade bonds" for investors who can handle some price declines in the near term. He prefers pre-refunded munis backed by a portfolio of Treasuries.

Brigati also recommends high-quality muni debt with intermediate duration, between three and seven years. "Short-term debt could be more risky now," he says.

He's also concerned about the Fed's support for the muni market because it puts the central bank in the position of picking winners and losers among issuers. "How would the Fed decide to buy New York City debt over debt from Syracuse?" he asks. "I don't think the Fed is well-equipped to handle all the complications. They could solve one problem but introduce another."

From: ThinkAdvisor