A Turbulent Stock Market Can Benefit State and Local Borrowers

Volatility in the stock market, like the swings on display in recent weeks, has possible upsides for state and local governments that are seeking to borrow money or refinance debt.

That’s because when equities become erratic municipal bonds can offer an attractive alternative for investors searching for a more stable place to park their money. U.S. stocks in 2018 endured their worst year since the 2008 financial crisis, with wild ups and downs in December.

“Volatility historically has been a good thing for us,” Ben Watkins, director of Florida’s Division of Bond Finance, said this week.

“There is no better place to be for safety and security than munis,” he added.

Data appears to back that up. Matt Fabian, a partner at Municipal Market Analytics, noted last week that, for the week ending Jan. 2, there were around $147 billion of assets in tax-exempt money market funds, which invest in municipal securities, like state and local bonds.

That’s an increase from the start of the fourth quarter last year when these funds held closer to $131 billion, according to data from the Investment Company Institute. In other words, upwards of $15 billion flowed into the funds over the course of about three months.

Fabian called the sum “tremendous” and pointed out that the funds have hovered in the ballpark of $130 billion since federal money market reforms took effect in 2016.

He went on to explain how the Federal Reserve potentially getting closer to the end of a cycle of interest rate increases could also marginally strengthen demand for municipal debt.

“Governments have good reasons to be optimistic as far as their ability to raise capital at advantageous rates this year,” Fabian said.

Watkins said another factor to consider with the current muni market is that while demand for municipal bonds is expected to be up, supply has been down. “We like that. That’s the Goldilocks market,” he said. “Could that change tomorrow? Yeah. It changes everyday.”

The lower supply of bonds is partly because the federal tax overhaul enacted in 2017 eliminated a popular municipal refinancing tool—tax-exempt “advance refunding” bonds.

State and local government entities borrow money for a range of reasons, but often for capital projects like roads, sewer systems and schools. Many municipal bonds are tax-exempt, meaning investors don’t have to pay federal income tax on their earnings from them.

In Florida, Watkins stressed that the state borrows when it needs to, not when municipal bond market conditions are favorable for issuers. “We don’t really play that game,” he said.

The state had two bond sales in the works this week, both of them refinancing deals. One was for $225 million of turnpike bonds, the other for about $75 million of lottery revenue bonds.

Randy Gerardes, a senior analyst with Wells Fargo Municipal Securities Research, notes that big states like California and New York tend to drive municipal market issuance patterns.

California alone was responsible for 26 percent of the net decline seen through late December in the volume of municipal bond issuance, according to a report from Wells Fargo.

The firm predicts a “modest” increase in the issuance of municipal debt overall in 2019.

Gerardes anticipates credit quality in the sector will remain generally solid this year. Even if there is a broader economic slowdown afoot, there is apt to be a lag before it affects state and local revenues.

Municipal bond investors will likely be looking ahead, though, and considering issues like softening real estate prices that could affect local property tax collections. The Conference Board reported last month that its Consumer Confidence Index dipped in December after a lesser decline in November. If that trend continues, it could eventually be reflected negatively in sales tax revenues.

One type of municipal debt that stock market volatility does not bode well for is pension obligation bonds—where governments borrow with the assumption that debt service costs will be less than the returns that their pension system can earn by investing bond proceeds.

Chicago Mayor Rahm Emanuel, who has less than a year left in office, has recommended the city pursue up to a $10 billion deal of this sort.

Fabian said that while “excess volatility should scare pension bond issuers away” Municipal Market Analytics believes there’s at least a 50 percent chance of Chicago selling the bonds.

“To their detriment,” he added.

Stocks have climbed in recent days amid optimism about trade talks between the U.S. and China, and signals from Federal Reserve officials that they may pause interest rate hikes.

Meanwhile, a strong jobs report from the Department of Labor showing employers added 312,000 people to payrolls in December suggested that the economy continues to hum along.

But there have been some ominous signs as well.

Apple last week cut its revenue forecast, citing weaker sales in China. And five Federal Reserve indexes of regional manufacturing around the U.S. declined in December.

There are also questions about the extent to which the stimulus from the 2017 federal tax code revamp, and its rate cuts, is beginning to wane, and uncertainty over the partial government shutdown, which was in its 19th day on Wednesday.

“It’s hard to tell,” Gerardes said last week, “how long the volatility will be with us.”