Federal Reserve Board building in Washington.
Leah Millis / Reuters
Yield-hungry investors pile into riskier assets and not just like speculative stocks
An example of how negative real rates distort prices is the market for municipal bonds.
Last month, investors took out $ 560 million in bonds issued by Chicago Public Schools (CPS) that were rated junk. The district’s 10-year bonds were rated at 1.94% and the 20-year at 2.24% – just 117-105 basis points above the AAA Muni benchmark returns. As the district’s finances deteriorated, borrowing costs have decreased. Imagine that.
Five years ago, Chicago schools had to pay an 8.5% rate of return – a 580 basis points above AAA fine – to sell debt amid fears that rising labor and pension costs would drive the district into bankruptcy. When asked if the district could borrow again, CPS CEO Forrest Claypool replied, “I don’t know.”
What difference does a pandemic make and the Federal Reserve’s commitment to keep interest rates near zero. Muni bonds are thinly traded and typically held for the life of the portfolio. Most buyers need fixed income assets that deliver constant returns, which explains the cravings for Muni bonds with higher yields.
“Buyers are just hungry for returns and the inflows into high yield funds have been astronomical, at least in the last few weeks,” a Muni market analyst told Bond Buyer. Increased demand has made it cheaper than ever for state and local governments to borrow and has compressed the price spreads between high and low-rated bonds.
Some Muni bonds are also tax-free, which makes them attractive to investors who expect Democrats to levy taxes. Tax revenue has been surprisingly buoyant on the real estate and stock market boom, so investors may shake off worries about defaults.
According to investment manager Nuveen, municipal tax revenue declined only 1% on average in 2020 while states and cities received hundreds of billions of dollars in federal funds. Schools in Chicago received twice as much money from the last $ 900 billion relief bill as the budget allowed. Now the Democrats want to provide an additional $ 350 billion in state and local government aid.
Financial advisors are calling on municipalities to use the lows to refinance debt. Pension obligations, popular in the face of low interest rates and the stock market rally in the 2000s, are back in vogue. According to S&P Global Ratings, pension bonds more than doubled in 2020 and are now sizzling.
Not so long ago, investors got burned by these bonds. Then, as now, local authorities issued debt at low interest rates and used the proceeds to replenish pension funds. Interest rate arbitrage seemed to benefit Muni’s borrowers and creditors. As stocks fueled in 2008, taxpayers faced bond payments and increased pension contributions to cover their pension defaults. Puerto Rico, Detroit, and Stockton and San Bernardino, California waived their bankruptcy debt. Fortunately for politicians, investors have short memories.
While Illinois and California are responsible for most of the pension bonds issued, Arizona communities including Tucson, Flagstaff and Pinal Counties have recently turned to the bond market to help fill their pension gaps. Pension bonds are not tax-free, but the returns are still attractive to investors. The City of Flagstaff’s deal last summer at an interest rate of 2.7% was oversubscribed 3.7 times.
Meanwhile, pension funds have invested in stocks and riskier assets to cover deficits and make up for low returns on their fixed income assets. “As interest rates stay low, bond yields will stay low, making safer investment opportunities less attractive to pension funds that need targeted returns,” S&P recently warned.
How this all ends is difficult to predict, but a good guess is that some new Stocktons and Detroits are likely. The Fed has stated that the cost of borrowing is essentially nothing, as a result, sovereign and corporate debt will rise, and eventually a price will be paid.
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