Money flow? Czech: Muni bond funds added nearly $ 2 billion in the week ended February 17, the fourth-largest record-breaking inflow by Refinitive Lipper US Fund Floss data, according to data. Shortage supply? You bet: Some analysts predict that in 2021 states and cities will bring the lowest amount of tax-exempt bonds to market in 21 years. Does monetary stimulus justify its case? True: The possibility of $ 350 billion in aid to state and local governments will help prevent widespread debt pressure.
Muni investors seem to have fully embraced the “HODL” mentality of the crypto group. In normal times, February sharp selling in U.S. Treasuries sent the 10-year benchmark nearly 30 basis points to 1.35. % (Monthly loss of almost 2%), resonating in the market for state and local bonds. Instead, the tax-deductible yield boundary remains constant; They finally started budgeting late last week.
By that time, municipal bonds had become the most expensive asset class anywhere. As Daniel Moran of Bloomberg News notes, yields on top-tax-free debt have fallen so low that even after being exempted from federal taxes, it makes more sense for investors to buy treasuries instead. It is fair to argue that Bitcoin is not worth more than $ 50,000, or that shares of Tesla Inc. should not be traded with 1,000 times more revenue. But it is at least possible to make the case that they should. Rallying is not every day as long as there is a fairly bad deal in one corner of the bond market.
Since most municipal bonds are exempt from federal income taxes, analysts prefer to estimate the relative value of the market using the muni-treasury ratio, which divides the yield on triple-a rated tax-free debt by the treasury with the same maturity. The high ratio indicates that Munis is relatively cheap – if it is above 100, investors are getting a tax deduction for free. Low ratio signals are getting Munis price.
If you believe that Delaware, Maryland, North Carolina, Texas and Virginia are as creditworthy as the federal government, their yields will be lower than the treasuries. For those in the top tax bracket, a taxable yield of 1.35% in 10-year treasuries equals 0.85% tax-free yield. The market usually does not reach that breaking point.
Everything changed last week. The 10-year muni-treasury ratio fell to a record 54%, meaning that tax-exempt bonds did not pay half of just 10-year U.S. notes. The 30-year ratio collapsed to 69% – before this year, the minimum was 86%. And for five-year securities, the muni-treasury ratio fell to 37.3%. According to Bloomberg Valuation Data, which tracks bond yields to 20 different states, five-year debt from all but Illinois and New Jersey yields less than five-year treasuries, and many state liabilities yield lower returns even after tax deduction.
This is not to surprise anyone in the Muni market. Citigroup Inc. analyst Vikram Roy called it “extraordinary greatness”. “You really have to scratch your head,” said John Flahiv, head of fixed-income investments at BNY Mellon Wealth Management. Bank of America Corporation’s strategists have called it “in vain” to call the bottom of the Muni-Treasury ratios.
The fear not mentioned here is that the muni market is particularly prone to painful setbacks. It is dominated by individual investors who hold shares of mutual funds or hold specific bonds in separately maintained accounts. In both cases, they do not respond well to monthly losses on secured assets. A clear example of this is the combination of “taper tantrum” and high-profile affected individuals in Detroit and Puerto Rico in 2013 from Muni mutual funds that year. Led to a pull of 60.7 billion, at least since 1992, with six losses in the last eight months of that year.
At this point it doesn’t have to be that way. From a pure public policy perspective, no one should be rooted against the cost of borrowing less to states and regions that are at the forefront of controlling the Kovid-19 epidemic and distributing vaccines. In fact, the reason why the tax-free bond supply appears to be so low this year is that municipalities are opting to sell more taxable debt, which gives them more flexibility to use the proceeds if it is more expensive upfront.
It is also clear that the Muni-Treasury ratios will not be permanent at impossible levels to buy the boundary of tax-exempt bonds. (2) The more embarrassing dynamics of this supply-demand imbalance is that fund managers are clearly approaching to buy long-term debt or risky securities. High-yielding muni funds raised $ 578 million in the week ended February 17, the second-largest inflow since adding $ 832 million earlier in the week. As is often the case with fixed-income investments, that strategy works until it is done.
(1) Yes, if the investor in the top tax bracket is convinced that taxes will be much higher in the coming years, then it can be concluded that there is still some value to the treasuries. But the law can also work in the opposite direction.
Brian Chappatta Bloomberg Opinion columnist, covering the debt markets. He previously covered bonds for Bloomberg News. He is also a CFA Charter Holder.