Interest rates

Rising interest rates hit municipal bond market

Municipal bonds are off to their worst start since 2011.

The early-year bond rout dragged S&P Municipal Bond Index returns down 1.1% through Jan. 20, adjusting for price changes and interest payments. The loss is an early sign that rising interest rates could make 2022 more eventful than last year, when federal stimulus and strong demand from home savers led to record low volatility and historically high prices. .

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Now investors are looking at these prices more cautiously. According to Refinitiv Lipper, Muni Bond mutual funds and exchange-traded funds took in $830 million net through Jan. 19, compared to $6.1 billion last year. After Fed officials signaled they could raise short-term rates sooner than expected, muni yields jumped alongside Treasury yields, with 10-year AAA muni yields rising 1.03% on Dec. 30 at 1.28% on Jan. 20, according to Refinitiv Municipal Market Data. Yields rise as bond prices fall.

State and local governments issue long-term debt securities in the municipal market of about $4 trillion, typically for capital projects such as highways and schools. Affluent investors like munis because most earn interest free of federal, and often state, taxes.

But rising interest rates are making outstanding bonds with a comparatively lower yield less attractive, a worrying possibility for anyone who owns or buys hedged debt. They are also raising borrowing costs for state and local governments, whose tax-exempt borrowing fell to $9.2 billion this year through Jan. 20, a four-year low. The city of Greenwich, Connecticut issued one-year debt at a net interest cost of 0.21% in the first week of January, down from 0.12% last January, according to Comptroller Peter Mynarski.

Some analysts also expect demand for munis to decline this year due to an anticipated slowdown in household savings, which have increased during the pandemic, especially for the wealthy.

The appetite for tax-exempt debt has long outstripped annual issuance. The imbalance has widened over the past year as high-income Americans shifted their savings and the windfall gains they made from blockbuster stock market gains into municipal bonds. Analysts do not expect these inflows to continue at the same pace this year.

Solvency could become more problematic for some struggling cities in 2022 as they continue to spend waves of federal pandemic aid. That aid, along with tax revenue from purchases made with stimulus checks and stimulus-fueled stock gains, helped bolster municipal credit in 2021, when improvements in public finances edged out Fitch’s downgrades. Ratings. In 2020, Fitch performed 80% more downgrades than upgrades as the pandemic crippled local economies and strained services.

Sustained inflation could also make credit problems worse, as it drives up the cost of government projects, services and cost-of-living-adjusted pension benefits, some analysts said.

“What is the value of the muni credit if the budget baseline is to increase by 5%” for several years in a row? asked Adam Stern, co-head of research at Breckinridge Capital Advisors. “Some places can handle it, some probably can’t.”

The defect is extremely rare in the municipal market. But debt issued by resource-strapped borrowers tends to decline under adverse financial conditions, driving down the value of investors’ portfolios and creating a dilemma for those who want to cash out.

In some ways, the heightened potential for volatility in 2022 marks a return to a more familiar investment environment after a year of unusual calm, which followed a year of Covid-related turmoil. After a liquidity crunch in 2020 at the start of the pandemic, the muni market in 2021 hit a record 113 days when yields on AAA mid-maturity bonds were unchanged from the previous day, according to data from Municipal. Market Analytics.

The year “2020 has been abnormal in terms of volatility,” said Michael Zezas, city strategist and head of U.S. public policy research at Morgan Stanley..

“2021 has been abnormally quiet. It’s a return to normal. »

Write to Heather Gillers at [email protected]

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