Investors Rally Around Muni Bonds As The US Federal Reserve lends A helping hand

Just like the global financial market’s volatility over the period of previous two months or so, since the coronavirus epidemic started spreading, US Municipal Bond prices have also been extremely volatile, especially during the last week. The Municipal Bond price volatility continued in the middle of the current week as well, as the prices first saw the biggest single-day gain in the last three decades followed by a historic fall. This has reportedly been happening due to a number of monetary policy changes and quantitative easing measures announced by the Federal Reserve as well as by the government of the United States of America to stave off the slowdown of the US and the global economy. These measures also provide both smaller and larger businesses full support and back up activities directed towards their survival during such tough times. Let us dig a little deeper into the entire idea.

The Fed lends a helping hand to the Muni Bond Market

On 25^th March 2020, after an announcement of an additional economic package by the Federal Reserve and the US government with the intention of trying to protect and rescue the US economy, the Federal Reserve entered the Muni Bond Market. It announced that it would be subscribing to about US $3.8 trillion worth of Muni Bonds, which are one of the essential sources of obtaining funds for local bodies such as the states, counties and municipalities in the United States of America.

The reason behind this new economic move is being discussed by experts a lot, and most of them have suggested that in the current economic and financial situation, the Federal Reserve is aiming to release the pressure from small businesses as well as local authorities in trying to keep the credit flow continuing during this period, as small businesses and companies are on the verge of shutting down. There is a lot of stress on these local bodies to make moves in trying to keep everyone healthy and at the same time trying to support the businesses that are heavily under stress, both operationally and financially.

While Munis are generally known to be amongst the least risky of assets, just a few weeks ago investors were subscribing to these bonds in large quantity in an attempt to de-risk from markets that were reeling under the aftereffects of the covid-19 outbreak. It is a possibility that this move would lead to a continuation of the trend last witnessed during the recession of 2008/09. Strong investor demand for state and local government debt culminated in greater than $100 billion in inflows last year. Muni’s tax-exempt status has made them especially popular following the 2017 tax legislation.

Muni market reaction after the Fed's rescue move

As soon as the Federal Reserve announced its move to buy Muni Bonds worth US $3.8 trillion to improve liquidity for the local and state-level administrations, the bond market reacted on an impulse, as the Municipal bond prices shot up, leading to the biggest single-day price gain in the last three decades. This was also followed by the members of the US Congress at the Capitol Hill as well as the US administration at the White House agreeing to a deal for a stimulus package which is expected to be worth more than $2 trillion, for the purpose of easing the impact of the market slowdown, which is a direct result of the coronavirus pandemic.

This led to a gain in the prices of securities across all maturity periods, resulting in a massive drop in yields for the securities of the shortest term maturities, which were hit the hardest because of a heavy sell-off this month as various institutional investors sold the highly liquid bonds when the investors were moving out of the market. The three-month benchmark yields were down by approximately 75 basis points to 1.8 per cent, and the benchmark yields for 10-year bonds fell 61 basis points to 2.06 per cent. This was also later followed by the Senate committee and the White House agreeing to another economic stimulus package to rescue the economy. This package is expected to consist of around US $500 billion that is expected to be used to back loan guarantees as well as offer support to US businesses and the local level administration of states and city councils.

What are Municipal Bonds?

When a local administration, a state government or municipal corporation wants to raise money to finance their capital expenditure programmes, such as for the purpose of the construction of highways, bridges or schools, they generally issue debt security, or a bond, which will work as precisely like any other corporate or government bond issuance. This debt security is called a Municipal Bond. The investors could be both individuals and institutions who could be looking for a fixed income return from their capital investments. These securities are generally low risk in nature and hence provide more moderate returns in comparison with the corporate bonds or equities. One reason why investors choose these municipal bonds is that any returns earned through these securities are exempt from Federal and Local taxes. This feature of these bonds makes them extremely attractive for high net worth Individuals or people who are consistently high-income earners. Over and above, providing tax exemptions to the investors, municipal bonds also have the lowest incidences of default in comparison to other asset classes. In the last five decades in the country, less than one per cent of the hundreds of thousands of issued Munis have gone down as defaults, making it one of the least risky asset classes ever.

Municipal bonds, also popularly known as "muni bonds" belong to the type of security which additionally consists of other instruments such as notes, warrants, certificate of participation and other similar financial instruments.

Generally, the features of a particular municipal bond could vary, depending on the terms and conditions set by the issuing authority and could also depend on the project for which the money is being raised and the requirement of its proceeds. In terms of structure, it could be set up to provide periodic interest payments and a balloon principal repayment at the end of its tenure or payment of interest and principal repayments on an ongoing basis. On a broader level, there are two types of Muni Bonds, which are general obligation bonds (GO) and a revenue bond. A general obligation bond is not issued against a specific project, and hence the cash flows and the repayment are not backed up by the revenues from any particular project. These bonds are backed up by the local government's ability to generate financial income through taxes and various other levies. A revenue bond, on the other hand, is backed up by a single or a multiple projects and the interest and principal repayment is done with the help of the consistent revenues generated or taxes being levied on the licensing of such a project. Revenue bonds are generally considered to be a little more secure if the underlying project is related to providing civic amenities by the local government or the municipal corporation.