Market participants say they aren't holding out for federal regulators to change a final liquidity rule for banks to include certain municipal bonds on an approved list of high-quality liquid assets.
Banking regulators earlier this week indicated at a hearing that they were open to revising the rule to add investment-grade munis as HQLAs after they were urged to do so by Sen. Chuck Schumer, D-N.Y. But analysts said the market should prepare for changes in how the municipal market achieves liquidity via banks in the long-term.
"There is no assurance that this will actually take place, so the market should treat these rules as final until further notice," Phil Fischer, municipal research strategist at Bank of America Merrill Lynch, wrote in a Sept. 5 weekly municipal report. "Over time, the muni market may be compelled to find a higher-priced source of liquidity if these rules become binding on banks."
Buy-side reaction runs the gamut from municipal participants who believe the rule will have minimal long-term impact to others who express concern over rising costs and declining liquidity for issuers and investors due to decreased ownership by large banks in the $3.7 trillion municipal market.
"Discouraging banks from buying or holding municipal bonds most likely will have the consequence of reducing the liquidity of certain municipal bonds normally pursued by the banking community," wrote J.R. Rieger, global head of fixed income at S&P Dow Jones Indices, in a Sept. 3 municipal market report.
While the potential extent of the impact is difficult to assess, limiting banks' investing options isn't good for the financial institutions or the municipal market, he said. Rieger touted municipals for their continued low default rate, lower volatility than investment-grade corporate bonds, and wide diversification provided by the "tens of thousands of issuers" in the market.
Following the recession, bank ownership has grown to $433 billion this year, or about 11.8% of outstanding muni debt, from $228 billion or 6.2% in 2009, Alan Schankel, managing director of fixed income strategy and research at Janney Capital Markets, wrote in a Sept. 4 a daily fixed income report.
The liquidity rule implements a Basel III standard requiring a stronger liquidity safeguard, which large institutions lacked at the height of the 2008 financial crisis.
The rule requires banks to maintain a minimum "liquidity coverage ratio," or LCR, defined as a ratio of HQLAs to total net cash outflows. Assets qualify as HQLAs if they can be easily and immediately converted to cash with little or no loss in value during a period of financial stress. But banking regulators did not include munis as HQLAs after determining they are not liquid and readily marketable.
Dealers have warned that excluding munis as HQLAs will cause banks to reduce their muni holdings, increasing borrowing costs for issuers, and reducing liquidity while adding to volatility in the muni market.
The liquidity rule principally applies to U.S. banking companies with at least $250 billion in total assets or consolidated on-balance sheet foreign exposures of at least $10 billion.
Corporate bonds, U.S. Treasuries, and foreign sovereign debt are included in the rule's HQLA list, which is categorized on the basis of risk and liquidity, with Level 1 viewed as the most liquid and least risky, and Level 2a and 2b considered less liquid but still readily marketable.
"If banks dial back municipal bond purchases, or worse sell munis to make room for [HQLA], it could put upward pressure on tax-free yields," Schankel said.
The Securities Industry and Financial Market Association, Bond Dealers of America and individual broker-dealer firms are all advocating that investment-grade munis should be included in the HQLA list based on their safety, liquidity, and trading activity.
Municipal experts agree these munis should ultimately make the cut.
"Obviously, any rule or regulation that limits the value of, or benefit of, holding munis disadvantages the asset class to some extent," Patrick Early, chief municipal analyst at Wells Fargo Advisors, said in an interview.
While the municipal market does not always offer the same kind of liquidity as corporate bonds or Treasuries, Early said major issuers that are highly rated, well understood, and trade regularly, are deserving of inclusion.
Meanwhile, others say the ruling could crimp bank support in the short-term market where a majority of variable-rate products require it.
"I'm more concerned about the potential impact on letters of credit, standby bond purchase agreements and direct loans," Nat Singer, a managing director at Swap Financial Group LLC, said on Monday.
"Not qualifying municipal bonds as HQLA would likely result in an increase in the cost associated with issuing variable-rate debt, which would serve to further exacerbate the unwanted, and costly, asset and liability management mismatch facing many muni issuers," he said.
"Including munis as HQLA will provide incentives for issuers to sell debt at the short end of the yield curve, which is where banks both provide credit support for variable-rate debt and focus their own purchases of fixed rate tax-exempt bonds," Singer said.
However, the market should take the new liquidity rule in stride, other sources said.
Roughly half of the municipal securities held by domestic banks are owned by the large banks subject to the new requirements, while many of those are already in, or working toward, compliance with the new regulations, Fischer said.
David Litvack, managing director and head of tax-exempt research at U.S. Trust Bank of America Private Wealth Management, said muni exclusion won't have a material near-term impact, since retail buyers, not banks, are the major driver of municipal bond pricing.
"Based on our analysis, the municipal holdings of banks that are actually subject to the liquidity coverage ratio is only a small percentage of total munis outstanding," he said in an interview.
"It is possible that a future rule change to impart HQLA status to certain munis could give them a pricing advantage over those that do not qualify," Litvack said. "However, we do not know yet what the basis for that distinction would be."
Overall the long-term impact should be manageable, whether munis remain excluded or not, sources said.
"Ultimately, especially if the rules are modified to allow for some inclusion of certain muni names in the future, I think the demand for munis outstripping supply will continue to support the asset class, even if banks have lost some incentive to hold the asset class," Early said.
"Munis still receive favorable treatment relative to corporate debt under Basel risk-based capital requirements, and currently, Basel seems to be the more constraining factor for most banks," Litvack pointed out.
Fed Chair Janet Yellen said at the Fed's meeting to approve the liquidity rule further bolsters financial stability, and will complement the Fed's enhanced regulations and supervision of banks' liquidity positions.
"The net effect over time may be that banks' share of outstanding municipal bonds decline, but we don't expect this to have a meaningful impact on tax-free interest rates," Schankel added.
Early said credit quality is a more important consideration going forward than the new liquidity rules for banks.
"Issuers that are considered to be financially-challenged, are lower rated, and have specific, high profile risk elements will continue to represent a higher level of liquidity risk than cleaner names -- robust bank participation notwithstanding," Early said.
Jeffrey Elswick, director of fixed income at Frost Investment Advisors, said municipal credits have varying degrees of liquidity depending on their size, name recognition, and other unique characteristics.
"I do believe, on margin, this will increase the required risk premium on municipal bonds over U.S. government bonds as some banks will likely cut back their allocation to the sector," Elwick wrote in an email. "But, this does not mean banks are not going to invest in any municipal bonds going forward; it's a change on the margin in my opinion.
"Certainly relative yields may increase marginally higher as banks are some of the larger buyers of some - not all -- municipal bonds. But the largest investors in the sector continue to be money managers and retail investors, and this ruling doesn't really color this sector from these two sets of investors," he added.
