At times like these, those who need cash will let go of what they can sell, not what they should sell. The weird dislocations in pricing this can create are, arguably, nowhere more evident than in the $4.1tn US municipal bond market. The highest quality, AAA rated, state government bond issues are in some cases priced with yields 100 or 200 basis points above where they should be, based on pricing in the near past or on rational expectations.
That means, in the words of one (usually cynical) large fixed income hedge fund manager, “high grade US munis are the cheapest fixed income relative value on the planet”. Yes, I know we should be spending our time washing our hands, cocooning and remote working. Still, financial people have to do something in between waiting for food and hand-wipe deliveries.
So take, for example, Texas, which is rated AAA, and which has about $59bn of state debt, mostly self-liquidating revenue bonds, supported by a population of more than 30m people. The 10-year yield of the state’s bonds on March 13 was 1.95 per cent, 90bp higher than it was a week earlier, and 150bp higher than the US Treasury 10-year. Also, for US citizens and residents, that 1.95 per cent can be grossed up by the Federal tax rate of up to 37 per cent, since interest income on muni bond issues is tax free.
US states, while subordinate in many ways to the federal government, are also sovereign entities in their own right. They have pre-eminence in many aspects of law, have their own policing powers and military forces, and have independent taxing authority.
States can, reasonably, be compared with euro area countries such as, say, Italy. On March 13, the (taxable) interest rate on Italian 10-year bonds was about 10bp higher than Texan bonds.
Texas, by the way, has a $9.7bn “rainy day fund” to cushion its two-year budget, which is required by law to be “balanced”. Independent state budget critics make a case that the state should have already covered the present value of unfunded state employee retirement benefits of about $65bn. But adding this to the bonded debt would leave Texas with less than one 20th of Italy’s debt (though with about half the population).
Of course under the US federal system, states cannot monetise their official debts. The Federal Reserve could, under Section 14 of the Federal Reserve Act, buy very short-term state and local government debt.
It never has, and even now the Fed board is strongly against any direct support of state debt. Progressive activists have tried pushing Congress to force the Fed to support the states, so far to no avail.
The lack of Fed support is one reason why state governments have mostly been very cautious borrowers. In the early 19th century there were several state government bond defaults, which led to the development of an almost entirely national state and local debt market.
According to Patrick Luby of CreditSights: “The latest data on the flow of funds shows non-US ownership of munis at $103.3bn, which is less than 2 per cent of the market. Anecdotally, we hear there is somewhat more foreign participation through bond fund managers, but it is not really significant.”
The recent muni sell-off can in large part be attributed to the particular weakness of the dedicated broker-dealer desks. Muni bonds are mostly an individual rather than an institutional product, which makes their unit trading costs higher.
Also, the tax-advantaged interest income of most muni issues makes it difficult if not impossible to run short positions. Dealers who “hedged” their muni bond inventory by shorting Treasury securities lost money on both the positions and the hedges. So even less capital from the risk committee.
The consequent lack of liquidity over the past week, Mr Luby says, led to a disproportionate sell-off. “Last week the muni mutual fund investors sold $1.7bn of shares, out of $846bn in assets. At the margin, that was a challenge for the market.”
For someone with cash who wants AAA assets, though, the panicked public was making an attractive offer.