Rising interest rates hit the municipal bond market

The early-year bond route has pulled returns on the S&P Municipal Bond Index to minus 1.1% through Jan. 20, counting changes in prices and interest payments. The loss is an early sign that rising interest rates could make 2022 a rocker compared to last year, when federal stimulus and increased demand from household savers led to lower volatility and record historically higher prices.

Now investors are eyeing those prices more. According to Refinitiv Lipper, the muni bond mutual and exchange-traded fund earned a net $830 million as of January 19, compared to $6.1 billion last year. Fed officials indicated they could lift short-term rates sooner than expected, with 10-year AAA muni yields up 1.03% from December to January 30, according to Refinitiv municipal market data, along with Treasury yields. The yield increased to 1.28%. Yields increase as bond prices fall.

State and local governments issue approximately $4 trillion in long-term loans to the muni market, usually for capital projects such as highways and schools. Prosperous investors reward munitions because most throw away interest that is exempt from federal, and often state, taxes.

But rising interest rates make outstanding bonds with comparatively low yields less attractive, a worrying prospect for anyone holding or buying muni loans. They also raise borrowing costs for state and local governments, whose tax-free borrowing fell to $9.2 billion as of January 20 this year, a four-year low. The City of Greenwich, Conn., issued a one-year loan at a net interest cost of 0.21% in the first week of January, up from 0.12% last January, according to Comptroller Peter Manarsky.

Some analysts also expect a fall in demand for munitions this year because of a projected slowdown in household savings, which has grown during the pandemic, especially for the wealthy.

The appetite for tax-free loans has long exceeded annual issuance. The imbalance increased over the past year as high-income Americans shifted the savings and benefits they got from blockbuster stock gains to municipal bonds. Analysts don’t expect the flow to continue at the same pace this year as well.

Creditworthiness could become a problem for some struggling cities in 2022 as they continue to curtail waves of federal pandemic aid. That aid, as well as tax revenue from purchases made with stimulus checks and stimulus-fueled stock gains, helped strengthen municipal debt in 2021, when the public-finance upgrade was slightly outweighed by a downgrade by Fitch Ratings. In 2020, Fitch downgraded more than 80 percent of the upgrades, as the pandemic strained local economies and strained services shut down.

Some analysts say continued inflation could also exacerbate the debt crisis, as it would drive up the cost of government projects, services and cost-of-living adjusted retirement benefits.

“How good is Muni Credit when the budget baseline goes up 5%,” asked Adam Stern, co-head of research at Breckinridge Capital Advisors. “Some places can handle it, other places probably can’t.”

Default is extremely rare in the municipal market. But loans issued by distressed borrowers tend to drop in prices under adverse financial conditions, reducing the value of investors’ portfolios and creating dilemmas for those looking to withdraw cash.

In some ways, the increased likelihood of volatility in 2022 marks a return to a more familiar investment environment after a year of unusual calm, which was followed by a year of Covid-related turmoil. According to Municipal Market Analytics data, after a liquidity crisis in 2020 in the early days of the pandemic, the muni market had a record 113 days in 2021, when yields on AAA intermediate maturity bonds had not changed from a day earlier.

“The year 2020 was unusual in terms of volatility. 2021 was unusually calm. This is a return to normal,” said Michael Zezas, municipal strategist and head of US public policy research at Morgan Stanley.

This story has been published without modification to the text from a wire agency feed