Progress, pitfalls ahead with Fed coronavirus muni aid

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Some stability in the municipal market is being marked by less outflows, Federal Reserve and government intervention, and slightly improving primary market volume. The market is not yet on solid ground amid the COVID-19 crisis, though, according to market participants, and caution is warranted.

The coronavirus has shaken the foundation of the municipal market and they said they are attempting to adjust to the sustained volatility.

“The Fed has taken rather bold steps, but we think it will need to seek out new life for the municipal securities market,” wrote Jeffrey Lipton of Oppenheimer & Co.

Some said recent data is not a chief indicator of market tone and noted it is still too early to point to the recent decrease in outflows — relative to the double-digit billions the market experienced in March, for instance — as proof of overall calm. Wednesday's ICI reports of $2.9 billion of outflows out of municipal bond mutual funds pales in comparison to the $20-plus-billion experienced in March.

In addition, the moves by the Federal Reserve to shore up the short end of the municipal market through its Municipal Liquidity Facility have received mixed reviews.

“These markets are so fickle at the moment; I would not attribute a momentary change in data to be indicative of a greater calm,” said Chris Brigati, managing director and head of municipal trading for Advisors Asset Management, who said that future negative data or news could still spook investors and the market going forward.

While Brigati said higher yields and the $2 trillion economic stimulus plan from the Federal Reserve Board have been aiding the market sentiment in recent weeks, he warned of the impact of potential volatility ahead.

Brigati said the market’s initial reaction to the Fed assistance was positive but its future steps remain crucial to market tone.

“Given the opaque and diverse nature of the municipal market, the exact mechanism by which the Fed executes the plan is incredibly important to get right,” he said.

As part of a $2.3 trillion stimulus package, the Fed recently announced that a $500 billion direct lending facility will be made available to state and local governments, including the District of Columbia, for relief purposes through Sept. 30, 2020. The Fed's new facility will purchase up to $500 billion of short-term notes, with the Treasury providing $35 billion of credit protection. But the program will directly aid only the largest issuers, at least for now, relying on those issuers to provide support to smaller localities.

“They could cause more harm to parts of the market, different issuers or even certain investors in the market depending upon how they go about their efforts,” Brigati warned.

Others agreed the effort is well intentioned, even if the initial plan needs some ironing out before it is put in action.

“In our view, the Fed’s intervention into the municipal securities market is unprecedented and illustrates the Central Bank’s commitment to hold a liquidity crisis at bay and prevent an insolvency crisis from emerging,” Jeffrey Lipton, managing director of municipal research and strategy and municipal capital markets at Oppenheimer & Co., wrote in his weekly Municipal Basis Points report on April 14.

“The Fed has taken rather bold steps, but we think it will need to seek out new life for the municipal securities market,” he said.

The new municipal facility should prevent "an issuer cash-flow crisis and to preserve an orderly and sustainable short-term market,” Lipton wrote.

“Further thought has to be given to the efficacy of the program,” Lipton said. “This is a short-term fix, and we have to remain skeptical over its longer-term impact and benefits upon credit.”

If the primary intent is to stabilize financial markets and abide by its congressional mandate of promoting maximum employment and price stability, then making an assessment of issuer management and oversight is not a realistic outcome for the Fed, Lipton said.

“In our view, the facility has a limited reach, made even more constrained by its eligibility requirements,” he wrote, adding that using U.S. Census Bureau population data, Fed acquisition of short-term notes under the Municipal Liquidity Facility would be limited to 26 local governments.

“The population constraints for local governments may only support some of the largest issuers in the muni space, at the expense of perhaps leaving those municipalities most in need without assistance,” Lipton said.

“While states may request that the Special Purpose Vehicle set up under the mechanism purchase Eligible Notes in excess of the applicable limit in order to assist political subdivisions and instrumentalities that are not eligible for the Facility, there is a lack of clarity as to how exactly this feature could be utilized, and we have to think about the far-reaching political implications of initiating such action,” he added.

Lipton noted that, so far, the Fed has been criticized for not extending the new-issue market purchase program to longer-dated municipal securities, and to other sectors, such as hospitals and higher education, as well as for its overly restrictive revenue limits that may not provide adequate benefit to a number of issuers. By comparison, “the reach into corporates includes longer maturities and fallen angels,” Lipton wrote.

Lipton believes the Fed’s effort shows early promise, but might have to undergo some revisions before it ultimately aids the market.

“The relief may prove insufficient and the Central Bank may come up with expanded authority under Section 13.3 of the Federal Reserve Act,” Lipton said. “But, as we consider current market behavior, there seems to be a favorable reaction to what the Fed has done to date all along the muni curve.”

Other market players said the plan is off to a good start, but is not a cure-all.

Moody’s Investors Service in a report said the muni portion of the program is a win-win for municipalities and provides a major increase in available funds at a seasonally appropriate time.

“The short-term municipal market, where annual issuance of notes maturing in 12 months or less totals approximately $40 billion, is unlikely to provide enough funding for states and local governments to bridge potentially large cash flow gaps without pushing yields materially higher to expand the market,” Moody’s analysts led by vice president and senior analyst Rob Weber wrote in an April 15 report.

The new Fed facility will increase available funds for state and local governments that need to borrow because of impending note maturities or gaps in cash flows caused by the economic disruption, they noted. But, municipalities are still on the hook for repayment.

"Funds borrowed through the liquidity facility will serve as a bridge until the coronavirus crisis and its effects abate," the analysts noted. “They are not a permanent solution to financial challenges resulting from the pandemic.”

“As states and the largest cities over one million residents and counties over two million benefit by drawing on the facility directly, smaller local governments will benefit indirectly from preserved market capacity,” according to Moody's. “The Fed program also provides for states and large local governments to re-lend funds drawn on the facility to smaller local governments within their jurisdictions."

The $500 billion, Weber pointed out, is more than 10 times the total amount of bond anticipation notes (BANs) and cash-flow notes issued in 2019 and equates to roughly 20% of state and local government own-source revenue, which totaled about $2.4 trillion in 2017.

“Note transactions completed in recent weeks show that the Fed’s previous actions to provide liquidity to state and local governments are working,” Weber and his team wrote. “Investment-grade municipal borrowers have been able to access the note market, though sometimes at a significant cost for borrowers at the lower end of the investment-grade scale.

According to the report, the coronavirus effects will both reduce and delay state and local government revenues, likely increasing the need to issue short-term debt.

“While it will take time to determine the coronavirus' ultimate effect on state and local finances, states that levy income taxes, for example, expect a three-month delay of significant revenue normally received by April 15 because the filing date has changed to July 15,” Moody’s analysts said. “Revenue declines will likely prompt some states to issue cash-flow notes to cover expenses and maintain sufficient financial flexibility as they manage spending and draw upon reserves,” they added.

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