On Monday, the Federal Reserve went all-in to support America’s shuttered economy. Among its most remarkable moves was its backstop of the $3.8 trillion municipal bond (“muni”) market, a critical source of financing for states, counties, and municipalities. The Fed hopes this will keep credit flowing to states and localities as their revenues—and the market for their debt—reel in the wake of the global coronavirus pandemic. As investor dollars rush out of the muni market, it is revealing troubling debts as well as questions about the role of fiscal federalism in a time of crisis.
State and local debt is facing its largest monthly drop in value since 1987, sending yields soaring nearly a full percentage point to 2.6% this week. Investors withdrew more than $12 billion from municipal bond funds last week, the highest weekly outflow on record, with some funds posting their largest one-day drop in a decade. Many funds now trade below the value of their assets, including those for New York State, suggesting that investors fear surging defaults.
Munis are normally considered among the safest of assets. Just a few weeks ago, investors were scooping up this debt in a flight to risk from markets roiled by the coronavirus. This is continuing the trend since the Great Recession of strong investor demand for state and local debt, culminating in more than $100 billion in inflow last year. Muni’s tax-exempt status has made them especially popular following the 2017 tax law.
But not all muni bonds are alike. Roughly a quarter of the muni market consists of general obligation bonds backed by state and local tax revenue. Defaults are rare here, even in recessions. The rest depends on revenue from specific projects, like toll roads and sports stadiums; or munis are issued for private entities operating with a public purpose, such as a hospital or an airport. It’s these last two types of bond that have been issued at greater rates in recent years, with demand high even for the riskiest—and higher yielding—unrated munis. These include debt for projects most likely to be impacted by coronavirus, such as airports and senior-living facilities.
Record-low interest rates and investor demand have driven state and local debt issuances to new highs, and these funds have in turn paid for everything from roads and hotels to private rail networks and hospitals. Yet some of these bond issuances are rarely traded let alone well understood; they’re often hyper-local and unique, and lumped into bond funds with bonds carrying different credit risks today. A top-shelf New York State muni fund, for instance, may contain bonds issued by the state’s dormitory authority alongside debt for Brooklyn’s Barclays Center or Erie County’s cash-in on its tobacco settlement.
Investors are now starting to ask questions. Private retirement facilities and elderly-care centers that issued debt on the public muni market are now seeing it trade at fire-sale prices of nearly 50 cents on the dollar. Interest rates are being reset too; a Kansas City art museum saw its rates go up from 1.92% to 5% last week after it shut down over coronavirus fears. And higher rates are spilling over into the whole muni debt market, which means that less money is available for investments and basic operations. The same goes for the states and localities now shelving or postponing $7 billion in bond offerings en masse, such as the $505 million for Virginia’s building authority and the $268 million for Massachusetts’ capital campaign. School districts, state agencies, public authorities, counties, and local governments across the country are now cutting back on borrowing.
State and local governments are likely to see their tax revenues hammered—at the same time as demands on these resources are set to grow, to some degree dependent on borrowing. Sales and gambling taxes account for nearly 50% of Nevada’s general income, for instance; a worrying sign when most of the state’s businesses (including its casinos) are closed, its residents are being kept indoors, and its visitors have vanished. States like California that depend on volatile income-tax receipts may be cushioned by rainy day funds, but others are more similar to Illinois, whose savings will pay for a “few minutes of budget spending.” Underfunded and overstretched pension obligations compound these woes.
Private entities that depend on states and localities borrowing on their behalf will also see increased risks. Hospitals that now face overcrowding from COVID-19 cases—and the crowding out of other services—are seeing their borrowing costs rise steeply. Stanford Health shelved an offering of more than $400 million in tax-exempt bonds; a Memphis, TN, hospital system just saw its annual debt payments rise by $4 million overnight. Airports now sit empty, as do stadiums and arenas. Colleges and universities have also emptied out, and those whose budgets depend on foreign students will likely suffer most.
Muni risks are hidden everywhere. The American Dream, for instance, a massive shopping mall in East Rutherford, NJ, is closed and unwell. Forced to shut its doors to curtail the spread of COVID-19, the mega-mall lacks revenue to pay back the $1.1 billion in municipal bonds that helped build its 3 million square feet of shopping and entertainment. Analysts predict The American Dream, a project nearly two decades in the making, may soon be forced to restructure its debt.
Investors are concerned that disruptions spawned by the coronavirus pandemic will harm even stable investments in the municipal bond market. Yet the largest muni bond issuers, such as New York’s Metropolitan Transportation Authority, which makes up more than 1% of the entire muni market, are unlikely to default. The same goes for tax-backed bonds from fiscally healthy states and school districts. Nevertheless, they will all need to access bond markets at some point and risk facing lower investor demand and higher rates.
But a tanking muni market should really concern states and localities with large, poorly funded pension obligations: they will face not only billions in new costs for, say, unemployment and healthcare but also reduced tax receipts from limited economic activity compounded by delayed revenues from the extension in tax filings to July 15.
With the Federal Reserve’s unprecedented backstop of the municipal bond market—and calls in Congress for the Fed to begin directly buying short- and long-term municipal bonds—the federal government is making a big bet on America’s states and localities. It’s hoped that these measures will achieve the goal of getting money into the hands of governments forced to ramp up spending in the wake of the coronavirus quarantine and help avert a potential crisis in the municipal bond market.
But the recent measures taken by the federal government to backstop states’ and localities’ debt may also portend radical changes in fiscal federalism. Regarding the degree to which future municipal borrowing is backed or bought by the federal government, possibly with direction on how those dollars are spent in tackling the coronavirus crisis, we may soon find that large capital outlays at the municipal level are more dependent on the support and administrative direction of the federal government than at any time in American history. This will be particularly true if the continued source of easy credit to municipalities (combined with a sense of crisis) encourages more fiscal profligacy and speculation among private businesses than before.
That is why it is critical for the Fed’s interventions in the muni bond market to be temporary, for states and localities to get a handle on their non-essential borrowing, and for municipalities to step back from Music Man-like spending sprees. Otherwise: Prepare for the municipal bond market crisis.
Michael Hendrix is director of state and local policy at the Manhattan Institute.
Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.
Photo by Livingpix/iStock