Municipal Market Forecasts and Trends

Government Finance Review, August 2015 | Go to article overview

Municipal Market Forecasts and Trends


The world of public debt management has undergone more change in the past two years than it has in the last two decades. A new regulatory landscape has emerged with the Dodd-Frank Act reforms, and after a 30-year bull market, with its steady decline in interest rates, the Federal Reserve appears to be increasing the federal funds target rate soon. It will likely increase borrowing costs for municipal issuers. Meanwhile, the municipal bond industry--which was known as the "sleepy market" for much of its existence --is suddenly grappling with new credit trends and negative headlines as a result.

Government finance officers need to be vigilant in navigating this changing landscape, especially when raising capital through the municipal market. Outlined in this article are areas that are particularly important to monitor over the next year.

MARKET FORECASTS

For most bond market participants, the single most important development to monitor over the next 6 to 12 months is whether the Federal Reserve raises the federal funds target rate. (When it rises, interest rates will likely rise, increasing borrowing costs for municipal issuers.) Related trends that finance officers should watch for include the following:

Timed Rate Hikes and Investment Exits. Mutual fund investors in recent history have tried to "time" rate-hikes or exit their investments before rates rise. This behavior has a large effect because mutual funds are the second-largest way investors invest in municipal bonds. In 2013, when investors fled the market, it was not able to digest the number of municipal bond fund redemptions, resulting in one of the most volatile summers in recent history. This year has already experienced rate-related outflows from municipal bond mutual funds. If these outflows continue or increase, issuers' costs for capital might rise from 75 to 190 basis points.

Growing Interest from Institutional, Opportunity-Oriented Investors. As mutual fund investors force redemptions, institutional investors are likely to moderate volatility by staying in the market, as they have done in the past. Banks and insurance companies have played a greater role as municipal bond investors during the last 18 months--in fact, banks have increased their municipal holdings by more than $60 billion during this time, according to Federal Reserve flow of funds report data. These data are publically available and can help finance officers in discussions with their advisors before coming to market because different types of investors are active during different times.

A Drop in Issuer Refundings. The 2015 trend of global interest rate increases has narrowed or closed the opportunity for municipal refundings. May and June 2015 municipal issuance data (from Bloomberg) showed a drop in issuer refunding as rates rose during those months. We expect refunding volume to diminish as the rate environment grows more adverse. This, coupled with a sustained drop in new-money issuance, could result in a net decline in overall issuance volume in the second half of the year--a silver lining for issuers planning to borrow in 2015, as the supply/demand balance becomes more favorable.

MARKET TRENDS

Perhaps the most important market stresses for issuers in the near term have to do with the situations in Puerto Rico and Chicago, Illinois.

Earlier this summer, Puerto Rico's governor told the New York Times that its debt load was not payable (1) and as a result, the island will likely see a broad restructuring and probably default on a significant portion of its $70 billion in outstanding debt--potentially the largest default in market history. This scenario, which has since come to pass, affects the general market. Mutual fund investors tend to react quickly to negative press and in most cases, mutual funds that own a substantial amount of Puerto Rico bonds (because they are exempt from federal, state and local taxes) also own other municipal bonds. …

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