A flood of cash pouring in? Verify: Muni bond funds added about $2 billion within the week ended Feb. 17, in response to Refinitiv Lipper US Fund Flows information, constructing upon a $2.6 billion influx within the prior interval that was the fourth-largest on document. Scarce provide? You guess: Some analysts estimate that states and cities in 2021 will deliver to market the smallest quantity of tax-exempt bonds in 21 years. Fiscal stimulus supporting its case? Certainly: The prospect of $350 billion in help to state and native governments ought to assist stave off any widespread credit score stress.
Maybe most remarkably, although, muni traders seem to have absolutely embraced the “HODL” mentality of the crypto crowd. In typical occasions, February’s sharp selloff in U.S. Treasuries, which has despatched the benchmark 10-year yield up nearly 30 foundation factors to 1.35% (for a month-to-month lack of nearly 2%), would have reverberated by now throughout the marketplace for state and native bonds. As an alternative, tax-exempt yields have been borderline immovable; they solely lastly began to budge towards the top of final week.
By that point, municipal bonds grew to become arguably the costliest asset class wherever. As Bloomberg Information’s Danielle Moran famous, yields had fallen so low on top-rated tax-free debt that even after accounting for the exemption from federal taxes, it nonetheless made extra sense for traders to buy Treasuries as an alternative. It’s definitely honest to argue that Bitcoin isn’t price greater than $50,000, or that shares of Tesla Inc. shouldn’t be buying and selling at greater than 1,000 occasions earnings. But it surely’s a minimum of doable to make the case that they need to. It’s not daily {that a} nook of the bond market rallies to such an extent that it’s objectively a nasty deal.
As a result of most municipal bonds are exempt from federal earnings taxes, analysts choose to gauge the market’s relative worth utilizing the muni-Treasury ratio, which divides the yield on triple-A rated tax-free debt by Treasuries with the identical maturity. A better ratio signifies munis are comparatively low cost — if it’s above 100, traders are successfully getting the tax exemption without spending a dime. A decrease ratio alerts munis are getting pricier.
If you happen to consider the likes of Delaware, Maryland, North Carolina, Texas and Virginia are roughly as creditworthy because the federal authorities, then it’s solely pure that their yields could be decrease than Treasuries. For these within the prime tax bracket, a 1.35% taxable yield like that on 10-year Treasuries is equal to a 0.85% tax-free yield. The market normally by no means reaches that breaking level.
That every one modified final week. The ten-year muni-Treasury ratio tumbled to a document low 54%, that means tax-exempt bonds have been barely paying half of 10-year U.S. notes. The 30-year ratio crumbled to 69% — earlier than this 12 months, the earlier low was 86%. And for five-year securities, the muni-Treasury ratio dropped to a puny 37.3%. Based on Bloomberg Valuation information that tracks bond yields for 20 totally different states, five-year debt from all however Illinois and New Jersey yields lower than five-year Treasuries, and plenty of state obligations would yield much less even after factoring within the tax exemption.
It’s not as if this caught anybody within the muni market without warning. Citigroup Inc. analyst Vikram Rai referred to as it “excruciating richness.” John Flahive, head of fixed-income investments at BNY Mellon Wealth Administration, stated “you actually gotta scratch your head” at valuations. Financial institution of America Corp.’s strategists referred to as it “futile” to name a backside to muni-Treasury ratios. Adam Stern, co-head of analysis at Breckinridge Capital Advisors, stated, “We’re looking for worth the place we are able to, and for those who can’t, maintain your nostril and transfer alongside.”
The unstated worry right here is that the muni market may be significantly vulnerable to painful reversals. It’s dominated by particular person traders who personal shares of mutual funds or particular bonds in individually managed accounts. In both case, they have a tendency to not react effectively to month-to-month losses on their supposed secure property. The clearest instance of this was in 2013, when a mix of the “taper tantrum” and high-profile distressed conditions in Detroit and Puerto Rico led people to tug $60.7 billion from muni mutual funds that 12 months, essentially the most since a minimum of 1992, as losses mounted in six of the ultimate eight months of that 12 months.
It doesn’t must be that manner this time round. From a pure public coverage perspective, nobody ought to root towards low borrowing prices for states and localities which are on the entrance strains of maintaining the Covid-19 pandemic in examine and distributing vaccines. In actual fact, a part of the explanation tax-free bond provide seems to be so low this 12 months is that municipalities are opting to promote extra taxable debt, which is extra pricey upfront however grants them better flexibility to make use of the proceeds.
But it surely’s additionally pretty apparent that muni-Treasury ratios can’t completely stay at ranges that make tax-exempt bonds borderline unimaginable to purchase.(2)One of many extra troubling dynamics of this supply-demand mismatch is that fund managers are clearly reaching to buy longer-dated debt or riskier securities. Excessive-yield muni funds drew in $578 million within the week ended Feb. 17, after including $832 million the week earlier than, which was the second-biggest influx ever. As is usually the case in fixed-income investing, that technique will work till it doesn’t.
(1) Sure, if an investor within the prime tax bracket is satisfied that taxes are going to go a lot greater within the coming years, then it is doable to make the case that munis nonetheless have some worth relative to Treasuries. However laws might doubtlessly work in the other way, too.
Brian Chappatta is a Bloomberg Opinion columnist protecting debt markets. He beforehand lined bonds for Bloomberg Information. He’s additionally a CFA charterholder.