Demand for Municipal Bonds is at Record Levels

Matty-Sways

After a 2019 buying binge, analysts project that municipal bonds mutual funds will continue that growth in 2020.

The S&P Municipal Bond Index is up 7.28% during the 12 months ended Dec. 27 mostly driven by high income individuals looking for tax relief.

“Basically all of that money has driven up prices,” said Nicholos Venditti, a portfolio manager at Thornburg Investment Management.

Following ten years of tight government budgets and new limitations on borrowing, a lack of supply in new bonds from cities and states has also driven up prices.

An interesting development is that the lack of supply in tax exempt bonds have driven investors to pour money into issued taxable debt. The 2017 tax overhaul barred certain investors from accessing the tax exemption for certain early refinancings. As a response the issuance of taxable bonds has doubled to about $65 billion. Limitations on the state and local tax deduction included in the 2017 tax overhaul have made munis particularly popular for investors in high-tax states like California. Municipal-bond interest is typically exempt not only from federal taxes but also from state taxes in the state where the bond is issued.

“The market is shrinking against really strong demand,” said David Hammer, head of municipal bond portfolio management at Pacific Investment Management Co.

The state of Illinois, ranked lower by ratings firms than any other state, benefited from the high demand. Illinois sold tax-exempt nine-year bonds in November at a yield of 2.8%. The interest on those bonds was 93% higher than what triple-A borrowers paid at the time of the deal, down from 102% during a similar deal in April.

Analyst expect that supply could begin to increase to meet the demand this year based on long-delayed infrastructure projects set to begin this year. After years minimal issuance, borrowing for new projects in 2019 approached prerecession levels for the first time in a decade.

In December, an unrated $59 million deal by the California Municipal Finance Authority attracted more than $500 million of orders, according to lead underwriter Barclays.

Nevertheless, investors hungry for tax-exempt debt scooped up 30-year bonds.

Speculative-grade or unrated debt made up 9.4% of the market as of June, a roughly $60 billion-dollar increase from 2012, according to analysis by Municipal Market Analytics.

Mutual and exchange-traded funds added an unprecedented $93.19 billion in 2019 through Dec. 24, with an also unprecedented $19.29 billion going to high-yield funds, according to Refinitiv. Mutual funds held $806.5 billion as of Sept. 30, according to the Federal Reserve, a 15% increase over the previous year.

Vikram Rai, head of municipal strategy at Citigroup, projects they will add another $70 billion in 2020.

“If we go through an environment where people start withdrawing money from their accounts, some of the larger funds will have to find a lot of buyers for their bonds, which could be hard given banks don’t own as many bonds as they used to,” said Dan Solender, director of tax-free fixed income at Lord Abbett, which oversees $27 billion in munis.

After 12 straight months of inflows, it is hard to predict when the march of investors into muni-bond funds will end, but it will, said Tom Kozlik, head of municipal strategy and credit at Hilltop Securities.

“That’s not going to happen forever,” Mr. Kozlik said.

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