Trading municipal bonds has become expensive as spreads increased drastically beginning in March when COVID-19's effects became clearer for market participants and volatility swept through broader markets.
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The spread between January 2016 and April 2020 trended consistently downward, the MSRB said, and continued until March 2020 when it reversed.
General spreads declined from around 95 basis points in early 2016 to below 55 basis points in February 2020. In March, spreads skyrocketed to 97 basis points before dropping slightly to 88 basis points in April 2020.
“To put it another way, the sharp increase in effective spread during the COVID-19 crisis (March and April 2020) wiped out nearly the entire reduction in effective spread realized over the preceding four-year period,” the MSRB wrote.
"The increase in effective spread as a result of the COVID-19 crisis was significant, though not unexpected given the severe market volatility, the liquidity crunch in fixed-income markets and the uncertainty surrounding financial asset pricing in general," according to the report. "However, the speed and magnitude of the increase was still surprising. The question now facing investors and market participants is how likely and quickly effective spreads might revert to precrisis levels, particularly for trades under $100,000 par value indicative of 'mom-and-pop' retail investors. The answer may depend on the market assessment of various risk factors in upcoming months, including general market risk, credit risk of municipal issuers and liquidity risk of the municipal securities market."
Trade size also did not matter as by the end of April, the spread had not returned to pre-COVID-1 levels for any of the trade size groups, the MSRB found.
Wu was not surprised that trading costs went up, but was surprised by how much.
“Even though the volatility settled down a bit by the end of April, the trading costs continue to be high,” Wu said. “Based on observations, there must be something else causing the costs to be high. Anecdotally, we heard that liquidity is continuing to be a problem.”
Wide spreads are caused by uncertainty of what municipal securities should be priced at, Wu said. He added that he thinks spreads should decline but is unsure of how quickly.
“My personal view is that spread should continue to decline, assuming the market settles down, meaning no more spikes in volatility and liquidity will come back to the market,” Wu said.
Liquidity is just not free, said Patrick Luby, senior municipal strategist at CreditSights.
“If the bid-ask spread is getting wider, then you know that the market is getting less liquid, that there is less willingness to take risk,” Luby said.
Over the next few months, spreads could come down due to upcoming redemptions.
“We’re coming into the summer redemption season when redemption flows make their annual spike in June, July and August,” Luby said. “So the influx of tens of billions of dollars of principal being returned from issuers to investors may potentially need to get reinvested in munis. If you increase demand and supply stays the same, you’d expect spreads to come down.”
There is still uncertainty in the market because of the pandemic, Luby said.
The MSRB’s report was “right on the money,” said George Friedlander, a municipal market and policy strategist. Liquidity concerns and credit concerns hit the market at the same time, causing large spreads, Friedlander said.
The municipal market will need federal help, which could possibly come through the recently passed HEROES Act, though it faces strong opposition from the Senate, Friedlander said.
Without signifcant help from the federal government, state and local governments are going to have substantially lower tax revenues, Friedlander said.
Friedlander expects spreads to go wider in the next few months.
“The market has not fully priced the credit risk concerns,” Friedlander. “If I’m right, then credit spreads go wider and bid-offer spreads go wider because there will be less liquidity. That kind of liquidity the Fed can’t do as much about.”
Credit concerns would be taken care of if Congress passes legislation similar to the HEROES Act, Friedlander said.
