- Perhaps the major problem that municipalities are now facing is the shortfall in revenue.
- This is being caused by the pandemic.
- The Fed’s statement of buying in the Municipal bond market has certainly helped yields but the response may be overdone given the restrictions the Fed has put on their purchases.
- What I do expect in the Muni market are more downgrades by the ratings agencies.
- The smaller the issuer the more due diligence I would be doing, especially drilling down to any loss of revenues.
Of all of the Fixed-Income markets, Municipals are the most disjointed. Yes, there are some large state issues, where liquidity can be found, but there are also very small issues, from small municipalities, that are not only general obligation bonds but also revenue bonds from school districts, water and sewer districts, and parking garages, that mark this landscape. Also, in the high tax states, the buyers are generally from those states where the tax issues are a large part of the decision of what to buy. This is also true of the ETFs and closed-end funds that buy these issues.
In response to the pandemic, the Fed’s Municipal Lending Facility is offering to buy up to $500 billion in municipal bonds issued by states, eligible cities, or other public entities like housing or transportation authorities that typically issue municipal bonds. However, to date, in this $4 trillion dollar segment of the bond markets, they have only bought one state issue which was issued by Illinois. The Fed bought part of a $1.2 billion “tax-anticipation note” issue. The Fed’s total purchase was $45.8 million, with principal and interest due for repayment in one year. Therefore, you can say that the Fed is “in” the Municipal markets, but just barely.
To be clear, the Fed has mandated very strict guidelines for their potential purchases. Each issuing entity may only borrow an amount up to 20 percent of their 2017 revenue, and only on terms up to three years. Although all 50 states plus the District of Columbia are eligible, only around 250 cities and counties across the country are eligible because the Fed requires cities to have at least 250,000 residents, and counties of at least 500,000 people. Many have argued against these stipulations and they may change but those are the parameters currently.
The Fed has also mandated that a state or regional entity can also use the proceeds to help cover eligible expenses for smaller units of government within their jurisdictions. If states used their borrowing capacity to do that, it would be the state that was responsible for the money and not some smaller municipality which would protect the Fed from any type of reorganization. This would be fine for the Fed, of course, but not so great for the state budgets.
One other issue, found in their lending program, is that the program is called a “liquidity facility.” However, it is also open to junk rated entities, there is no definition of parameters here, meaning that the Fed could be taking on credit risk as well, if it so chooses. This has not happened yet but time and tides will open up this possibility and so it must be taken into account.
One of the problems, perhaps the major problem, that municipalities are now facing is the shortfall in revenue. This is being caused by the pandemic. Whether it is hotel taxes, or gas taxes, or airport taxes, with many people not travelling, the pinch is on. I recently pointed all of this out to the city of Fort Lauderdale and I said that they only had four real choices. Issue new bonds (very problematical at present), raise taxes (almost impossible now), cut expenditures (all politicians hate this), or try to improve the return on their investment portfolios. The response to my last suggestion was a deafening silence.
The Fed’s statement of buying in the Municipal bond market has certainly helped yields but the response may be overdone given the restrictions the Fed has put on their purchases. It is certainly the first time, ever, that the Fed has entered this market, but I wonder about the real impact of their statement given the conditions that they are using. More helpful, to all of the fixed-income markets, would be the Fed lowering rates even further, but we are awfully, if not to say dangerously, close to the baseline of Zero, which the Fed does not seem to want to cross, I agree.
What I do expect in the Muni market are more downgrades by the ratings agencies. These agencies will look at the loss of revenues, and the stagnant expenditures, and not be pleased by what they see. Also, Municipalities are much less savvy than corporations, in refinancings, as political considerations always seem to cloud business calculations. I would be especially cautious about buying bonds from small issuers now as they may get left behind in any pick-up in the more liquid names.
For those of you with Municipal portfolios, I would be taking a hard look at what profits that you might have now. I am not suggesting any kind of panic selling but some careful considerations of what you own. As I said earlier, the smaller the issuer the more due diligence that I would be doing especially drilling down to any loss of revenues, in your calculations. Any and/or every dollar spent can be a dollar earned, to you. If you get what I mean.
Another consideration is what is happening now in Congress. The House-passed HEROES Act would extend the Fed’s program through the end of 2021, increase the maximum loan term to ten years and reduce the interest rate on MLF loans to the Federal Reserve’s discount rate. This is regardless of the borrower’s credit quality, interestingly enough.
So, the Fed was created by Congress in 1913.. Congress does have the authority to provide guidance to the Fed, even though I’ve heard and felt that it may be seen as crossing the line in telling the Fed what it may or may not do. Little seems to have found its way to the Press, about Congress’s potential intrusion.
Forewarned is forearmed.
Here is your shield!