Throughout 2020 we have been taking an in-depth look at the changing landscape of the municipal bond market – and this article focuses on the supply and demand dynamic shaping the market.
Not since the Tax Reform Act of 1986 have we seen such change impacting our market, affecting both the structure of issues being offered as well as the composition of investors who are purchasing these issues. Here, we address some of the significant changes currently driving municipal bond issuance volume and structure in this market and provide insight into how these changes may affect the way your organization finances its capital projects.
A variety of market factors work together to influence the level of interest rates and the shape of the yield curve in the municipal bond market. Expectations regarding the level of inflation, interest rate decisions and open market operations by the Federal Reserve, global events that shape economic expectations, and the influence of fiscal policy – including changes in tax rates – are just several of the factors that can influence interest rates.
For example, the Tax Cuts and Jobs Act of 2017 (the Act) reduced the corporate tax rate from 35% to 21%, thereby reducing the attractiveness of municipal bonds from a tax perspective for corporations and many banks that are structured as C-Corp entities. However, another significant factor that helps determine the level of interest rates for municipal bonds is the relative supply and demand for these bonds.
If you remember from Economics 101, the relative supply and demand for an item will help determine its equilibrium price. As demand rises, price will also rise for a given level of supply. Likewise, as supply rises, price will decline for a given level of demand. This same market dynamic holds true in the municipal bond market. As the demand for municipal bonds increases, the price of bonds will also increase, assuming all else is held constant. And, since there is an inverse relationship between price and yield for bonds, when the price of municipal bonds increases the yield for those bonds will decrease.
Let’s take a closer look at the recent supply and demand for municipal bonds, and the resulting effect we have seen in the level of interest rates in the market.
Demand for municipal bonds
Although corporate tax rates were reduced in 2017 by the Act, income tax rates for high-income individuals remained unchanged. And, with the imposition of the state and local tax (SALT) deduction cap of $10,000, high-income individuals living in cities and states with high taxes now face a higher federal tax burden. As a result, the demand for municipal bonds among high-income individuals, especially those living in high SALT states, remains robust.
Another key factor in the recent strong demand for municipal bonds is their relative value compared to other taxable asset classes. With the current level of interest rates for AAA-rated municipal bonds trading at 110% to 125% of comparable Treasury securities (compared with their more typical trading range of 60% to 85%), municipal bonds remain attractive to investors in this environment.
The chart below—ICI Fund Flows—shows the demand for municipal bonds over the last 30 months. This chart provides the weekly flow of funds moving into (green), and out of (red), municipal bond funds. As money is flowing into these funds, it needs to be invested by money managers through the purchase of municipal bonds, thereby increasing the demand for municipal bonds in the market.
As shown in the chart, with the exception of a few weeks in March and April of this year, the flow of funds into the municipal bond funds has been strong over the last 18 months.
Supply of municipal bonds
The supply of municipal bonds is influenced by several factors, and is determined by the volume of bonds maturing or being called by issuers (which reduces the supply in the market), together with the volume of bonds being issued to finance new projects or refund outstanding debt (which increases the supply in the market). The combined effect of these volumes constitutes the net new issuance of bonds coming to market as depicted by the light blue line in the chart below.
As shown in this municipal supply profile chart, with the exception of the fourth quarter of 2019, the net issuance of municipal bonds over the last 18 months has been mostly flat, with many of those months experiencing a negative net issuance of bonds.
Resulting interest rates
With a strong demand for municipal bonds (as depicted by the consistent flow of funds into municipal bond funds) and a mostly flat to negative volume of net new issuance in the market, we would expect the price of municipal bonds to increase (with a corresponding decrease in the yield of these bonds). As the chart below shows, except for the few weeks in March and April when money was moving out of the municipal bond funds, interest rates have in fact been extremely low and declining as expected.
What are the implications for the future?
As we look to the future regarding where interest rates may be headed, there are a few factors to consider on both the supply and demand side of the equation. The demand for municipal bonds is significantly impacted by changes in tax law. As we head into a presidential election this fall, the potential for a change in tax rates for corporations or individuals could influence the demand for tax-exempt income provided by municipal bonds. In addition, any uncertainty in the market that may cause a flight to quality like we saw in March and April at the start of the pandemic could reduce the demand for all asset classes (including municipal bonds) in favor of safe haven assets such as short-term treasuries.
On the supply side of the equation, an infrastructure bill being considered by Congress could provide a host of new financing vehicles intended to encourage much needed infrastructure improvements throughout the nation. This has the potential to significantly increase the volume of municipal bonds coming to market over the next several months or years as projects are being financed. In addition, there is also discussion that Congress may bring back the ability to advance refund tax-exempt bonds on a tax-exempt basis, which could also significantly increase the volume of municipal bonds coming to market.
With all the political, legislative and pandemic related factors that have the potential to produce significant change in the coming months, the fourth quarter could prove to be a very interesting time for the municipal bond market.
Further reading on municipal bond market influences
This article is the fourth in a four-part series of articles:
- Alternatives to advance refundings post tax cuts and jobs act of 2017
- Changing investor preferences for municipal bonds
- Increasing use of private placements in the issuance of bonds
UMB Bank Public Finance is committed to helping healthcare institutions fulfill their quality-of-life and growth aspirations. Visit umb.com to learn more about how we can support your organization, or contact us to be connected with an investment banking team member.
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