The municipal bond market is booming, thanks to a growing economy and Trump-era changes in tax taw. However, some financial analysts still warn against investors buying bonds from rural municipalities.
Municipal “muni” bonds are bonds sold by cities, counties, state governments, or other local public entities to finance local infrastructure projects, like bridges and schools or even fiber optic cable networks. The interest from municipal bonds is tax-exempt, which makes them particularly attractive to investors.
The Tax Cuts and Jobs Act capped the deduction for state and local tax payments at $10,000 per household, which is driving some wealthier investors to buy muni bonds to generate more tax-free income, according to analyses by both Charles Schwab and by NYU economist Lawrence White.
But White also said the TCJA has had a “little bit of an effect, but only a little bit” on the muni bond market. He mostly attributes the surging muni bond market to the overall economic boom.
“I’m a little puzzled by people make a bigger deal out of it than is warranted,” he told InsideSources. “In general, we’ve got a more robust economy, we’ve got tax revenues increasing for municipalities and for states, and that allows them a bigger cash flow to support more borrowing. It’s the more robust economy we’ve had over the last ten years.”
Data from the Municipal Securities Rulemaking Board (MSRB) shows that the sale and trade of muni bonds increased steadily 2014-2018. While the number of non-payment related default rate declined from 113 in 2017 to 104 in 2018, the number of payment delinquencies increased from 399 to 432.
According to the MSRB, the average default rate of a muni bond is 0.18 percent as opposed to the 1.74 percent default rate for corporate bonds.
But that doesn’t mean all muni bonds are safe. At the beginning of 2019, Charles Schwab “cautioned” investors interested in making a quick buck in the muni market.
“We expect economic growth in this cycle to peak and anticipate a potential slowdown in 2019,” wrote Cooper Howard, a Charles Schwab research analyst. “As a result, muni investors should consider higher-rated issuers (AA/Aa and AAA/Aaa). Lower-rated issuers typically have less financial flexibility to pay debt service. During an economic downturn, their finances could be further strained.”
Howard specifically warned investors against buying bonds from certain high-debt states, particularly in the Rust Belt. Illinois, Michigan and Pennsylvania, for example, are especially risky because 45 percent of Illinois’ capital expenditures, 40 percent of Michigan’s and 43 percent of Pennsylvania’s are pensions, post-employment benefits and debt service.
“[It’s] been an uneven thing, and there have been defaults, Puerto Rico being a major example of this (because of Hurricane Maria), the city of Fresno, California being another,” White said. “And [there are] worries that the state of Illinois’ future obligations, like pensions to state employees, may be difficult to satisfy and that might call into question their ability to repay their bonds. So it’s a mixed story.”
In a July 2019 analysis, Howard found that many other Midwestern states, like Ohio, are facing demographic and economic decline, which makes their muni bonds riskier. Howard said investors should avoid areas that are “heavily dependent on one industry, have an aging population and are rural.”
“Rust Belt cities today generally have declining populations and a higher-than-average number of residents who are unemployed,” Howard wrote. “That usually results in lower tax revenues for the municipality and therefore less financial flexibility to meet debt service. This is a negative for bondholders.”
But if investors don’t buy muni bonds from those areas, it can be hard for local governments to invest in projects that will benefit their local economies in the long run. Even though Howard said the muni bond market is “off to its hottest start in five years,” spreads for lower-rated municipalities are “near historic lows.”
“We are also cautious on issuers that would be negatively affected by a prolonged trade war, such as issuers highly reliant on the agricultural industry in the Midwest, southern border cities, or port cities,” Howard wrote.
Even though the Federal Reserve cut interest rates in July in anticipation of growing economic turmoil due to trade tensions with China, investors are eager for more muni bonds, the Wall Street Journal reported, which could signal hope for rural areas, even though California, New York and New Jersey saw the biggest jump last month in muni bonds.
“California investors in the state’s top tax brackets may still achieve higher after-tax yields by sticking with in-state munis,” Howard wrote in a May 2019 analysis.