Has the coronavirus pandemic created an ideal market for municipal bonds?
The global financial markets coronavirus rollercoaster ride along with cultural and politic seismic shifts have some investors longing for investment stability. The municipal bond market is an attractive vehicle for those looking for tax advantages, portfolio diversification and contentment with conservative performance.
“From an investor standpoint, it’s a good thing,” said Brandon Adams, senior portfolio manager at RKL Wealth Management in Manheim Township, Lancaster County.
Adams said municipal bonds – part of the fixed income market appeal to a particular type of investor, mainly retail and individual investors. They are rarely purchased on the institutional level, or by pension funds.
The “Coronavirus Crash,” during which the global stock market sustained its most perilous dive since the Wall Street Stock Market Crash of the 1929 is generally blamed for the “COVID-19 Recession” and partly credited with a second look at the municipal or “muni” bond market.
The “municipal bond market has been trending in the right direction” said Paul Marrella, a wealth manager at Marrella Financial Group LLC in Wyomissing. “There is always the worry (on Wall Street) and the risks you have to look at [include] airports and big cities and [may be] a genuine risk of default.
He pointed to the continuing exodus from large COVID-19-hit cities, such as New York, to the suburbs and even neighboring states like Pennsylvania, as a potential risk for the Big Apple’s future bond borrowing power.
“Remember, you are loaning entity money” to complete capital public projects, Marrella said.
Revenue shortfalls possible in cities
Cities and other bond-issuing entities such as nonprofits or airports could be experiencing revenue shortfalls, and their balance sheets, or performance records, was worth keeping a close investment watch on when making bond buying choices, he said.
“When tax rates go up municipal bonds become an attractive investment,” Marrella said.
Municipal bonds are typically issued by federal, state or local governing entities to finance capital projects such as roadways, or water or sewer projects. The purchaser of the bonds is effectively lending money for the project, at a set interest rate over a set amount of time. Short-term bonds may be up to three years, while long terms bonds typically run for 10 years.
Interest is paid along the way and when the bond matures, the principal is repaid in full.
Municipal bonds may also be issued as a “through way” for nonprofit capital improvements such as public school districts, universities or hospitals.
Bonds are not subject to federal income tax. For some investors being tax free is an advantage.
“It makes sense for those in a high-tax bracket or want diversification in their portfolio,” Adams said.
When interest rates go down, generally bond prices go up, which is a benefit to those who purchased bonds at a lower price. As a rule there is an inverse relationship between interest rates and bond prices, he said.
On the down side interest rates for municipal bonds are among the lowest paid of all investment options. It is important to know the credit worthiness of the entity from whom the bond is purchased, Adams said.
For bond issuers now is a good time to borrow because interest rates are low.
For investors, Marrella said, if taxable and tax-free bond rates are both paying 2%, the tax-free bonds are a better investment. “You have this tradeoff between risk and reward,” he said.
Adams said municipal bonds are primarily offered on the primary and secondary markets. “Primary is when a municipality goes out and issues a bond for the first time and seeks investors,” he said.
Secondary market sales are not available on a traditional exchange after they have been issued, and they are not traded on a regular basis, according to the Fidelity Investment website. Brokers or broker dealers handling bonds can execute secondary market transactions – an investor who wants to purchase a particular type of bond for its location, quality rating and its purpose.
The bond issuing triggers debt service in the short term, intermediate and long term from three to 10 years, or beyond 10 years, respectively.
Interest rates down
Year to date, intermediate bonds have been taking advantage of a low interest rate environment, and therefore “trying to lock up that debt” at the lower rate, Adams said.
“Interest rates have plummeted this year,” he said. “In 2019 and when the pandemic hit in the first half of 2020, The Federal Reserve Bank was at 0.25 basis points.”
Basis Points (BPS) is a common unit of measure in finance for interest rate change. One basis point is equal to 1/100th of 1%, Adams said.
“This lowers the yields, which is very beneficial to municipalities that want to take on a project for infrastructure and lower their costs for that five-to-10-year period,” Adams said.
That means as treasury yields have gone down, AAA-rated municipal bond rates have gone down. “They can issue bonds at lower interest rates and lower costs,” he said.
The impact to investors is timing.
For those who owned municipal bonds prior to interest rates dropping, the price of those bonds goes up. “As an investor, generally speaking…you’re making money,” Adams said. An effective Covid-19 vaccine, which could permit a return to normal life and pre-coronavirus activity levels, would be a plus for the municipal market, too.
“They would get more tax revenue and it would strengthen their balance sheets,” he said.
The current strength of the balance sheet is the biggest question investors should be asking when considering buying municipal or non-profit entity bonds.
“If we get another stimulus package out of congress that would, generally speaking, be another positive for the municipality market,” Adams said. “We don’t know what that would look like, but there could be some potential help for municipalities.”