The Municipal Bond Market Outlook

There are several key factors to consider, whether you are a local government or an investor in municipal bonds. The municipal bond market is experiencing a wave of activity as issuers look to refinance existing taxable debt and reissue it as tax-exempt. Increasing fears about inflation and fiscal austerity in the near term are also driving demand. In addition, the Omicron variant of the tax-exempt bond market presents manageable credit challenges.

Fiscal austerity in 2022

Across the globe, 85% of the population will be under the shackles of austerity measures by 2023. The measures are typically taken by governments that find it difficult to borrow money, but they can also be implemented at any time.

Recently, countries like the United States have run large budget deficits. The United Kingdom has implemented severe belt-tightening policies. These include cutting social programs, scaling back government pensions, and reducing workers’ rights.

However, the latest economic research is highly critical of economic retrenchment in crisis. It argues that the idea of a ‘fiscal black hole’ is dangerous and has no merit.

The government’s fiscal balance is one of three sectoral financial balances in the country’s economy. It consists of three components: the government’s expenditures, borrowings, and taxes.

The public’s acceptance of austerity measures depends on how they are framed. The term’mediamacro’, coined by Wren-Lewis, refers to the role of the media in reproducing economic illiteracy.

Rising fear of inflation

Despite a positive technical backdrop, the municipal bond market experienced a decline in the second quarter. Investors have been focusing on the possibility of a rate hike by the Federal Reserve. This has injected a great deal of uncertainty into the market and has made the municipal market perform worse than it should.

Inflation fears continue to be a major worry for investors. The Federal Reserve has telegraphed a desire to raise the federal funds rate by 300 basis points. It has also signalled that it is likely to reduce the size of its balance sheet. Those fears have been exacerbated by an economic slowdown, as the GDP growth rate has slipped.

Inflation concerns are also impacting bond markets in the U.S. The Consumer Price Index increased by 7% in December. This was far higher than analysts expected, exacerbating fears that inflation could accelerate and impact fixed-income markets.

Tax-exempt supply reverses as issuers refinance existing taxable debt and reissue it as tax-exempt

Increasing the supply of tax-exempt municipal bonds can pose a challenge to the values of existing bonds. This is especially true if the issuance of new tax-exempt bonds results in a principal loss to the issuer.

Tax-exempt bonds are a useful tool for counties, municipalities, and nonprofits. They facilitate the budgeting of long-term investments and facilitate economic development. They also allow taxpayers to take advantage of the SALT deduction, which reduces the federal tax burden on higher-income individuals.

The SALT deduction includes property taxes, income taxes, and other taxes. When the deduction is removed, high-income individuals see their absolute tax rate rise. Congress could work to bring the deduction back to pre-2017 levels.

The new law also put a cap on the advance refunding allowance, which limited municipalities’ ability to issue debt in the taxable realm. This limited the supply of tax-exempt bonds and forced municipalities to issue more taxable debt. A reversal of the restrictions could increase the supply of tax-exempt municipal bonds.

The Omicron variant presents manageable credit challenges

Although the Omicron variant of the coronavirus continues to cause uncertainty in the markets, the municipal bond market is well positioned to withstand the threat. The market enters the new year with strong credit, supportive technical conditions and a strong supply of funds. However, market participants are increasingly worried about sustained price increases in 2022. This may negatively affect the credit fundamentals of issuers. In addition to inflation, emerging risks include climate change, labour shortages, and a less reliable federal funding environment. A collaborative multi-sector approach is essential in navigating the dynamic market environment.

Market participants continue to digest the December policy shift by the Federal Reserve, and sentiment has shifted between complacency and alarmism. However, the positive year-end starting point will likely lead to challenges in 2022. Although the number of municipal defaults was lower than in the period from 2017 to 2020, it was higher than in the period from 2016 to 2020. The retirement/nursing home sector was particularly affected, with 54 per cent of all defaults occurring there.