Former Senior Research Assistant - Hutchins Center on Fiscal and Monetary Policy
Director - The Hutchins Center on Fiscal and Monetary Policy
Senior Fellow - Economic Studies
The beginning of the COVID-19 pandemic strained many sectors of the economy, including the municipal bond market, prompting an unprecedented intervention by the Federal Reserve. This post summarizes the latest research on the effectiveness of the Fed’s response to COVID-related distress in the muni market, which finances more than 50,000 local and state governments and other entities.
How did COVID-19 affect the muni bond market?
Prior to the pandemic, the muni market was ebullient. According to Morningstar, between the beginning of 2019 and February 2020, investors put $105 billion into muni mutual funds and exchange-traded funds, the largest annual influx in the muni sector in 25 years.
COVID-19 hit nearly every sector of the financial market. In the muni market, investors apparently feared that state and local government revenues would fall and spending would increase, hurting governments’ ability to service their debt.
In March 2020, investors pulled a record $45 billion from muni funds. Municipal bond prices dropped, and the yield on muni bonds rose sharply above the yield on comparable U.S. Treasuries. The yield on muni bonds typically is about 80% of that of U.S. Treasury bonds, reflecting the fact that interest on the former is exempt from federal income taxes and interest on the latter is taxable. By the end of March, muni yields were nearly four times that of Treasuries.
With few investors willing to buy municipal securities, state and local governments struggled to borrow in the face of COVID-related budget constraints.
What did the Fed do?
During the Great Recession, the Federal Reserve did not intervene in the muni bond market, nor did it lend to state and local governments. The COVID-19 recession was different.
The $2.2 trillion CARES Act, passed by Congress early in the pandemic, provided $454 billion to the Treasury to be used to backstop Fed lending to businesses and state and local governments. In general, the Federal Reserve will lend only if it expects it will be paid back in full; the appropriation was intended to absorb any losses that the Fed incurred.
In March 2020, the Federal Reserve made municipal securities eligible for its Commercial Paper Funding Facility (CPFF) (meaning the Fed was willing to buy short-term muni debt directly from state and local governments) and for the Money Market Mutual Fund Liquidity Facility (MMLF) (meaning that the Fed would make loans to banks secured by municipal securities bought from money market mutual funds). Both actions were intended to stabilize municipal bond prices and state and local governments’ ability to borrow through the public health crisis. Both the MMLF and CPFF expired on March 31st, 2021.
In addition, the Fed launched the Municipal Liquidity Facility (MLF) in April 2020 to lend up to $500 billion directly to states and local governments with populations above a certain threshold; the list of eligible borrowers was later expanded to include more issuers. However, only the state of Illinois and the New York MTA made use of the program, borrowing $3.2 billion and $3.36 billion, respectively. The MLF stopped lending on December 31st, 2020, after Treasury Secretary Steve Mnuchin withdrew Treasury support.
Did the Fed’s intervention work?
Fed intervention was intended to prevent the deepening COVID-19 recession from pushing up muni rates and starving state and local governments of cash. Within days of the Fed’s initial intervention in March 2020, muni yields began a sharp decline that would continue through the summer of 2020. By the time the CPFF and MMLF expired, muni rates sat at about 50% of Treasury rates and have remained there since.
Despite low take up of the Municipal Liquidity Facility, research suggests the availability of the program was quite effective at easing investors’ concerns and stabilizing muni bond yields. Based on the historical relationship between unemployment and muni bond rates, Michael D. Bordo of Rutgers and John V. Duca of the Dallas Fed estimate that muni yields could have risen by as much as 8 percentage points more than they did in mid-April had the Fed not launched the MLF on April 9. “That these effects occurred far in advance of the opening of the MLF and given the very modest borrowing by municipal entities at the MLF together imply that the announcement of this new facility had a pronounced and rapid backstop effect,” the authors say. “These results along with others imply that there was systemic risk in the muni bond market in the COVID-19 pandemic, that was not the case for the isolated, but prominent, muni defaults in the prior half century.”
In a paper presented at the Hutchins Center’s 10th Annual Municipal Finance Conference, Andrew Haughwout, Benjamin Hyman, and Or Shachar of the New York Fed show that the introduction of the MLF particularly lowered yields in the private market for low-rated issuers, and allowed local governments to more easily borrow money to retain employees despite falling revenues and higher spending due to the pandemic. By comparing issuers just below and above the population eligibility cutoff for the MLF, Haughwout and co-authors find that eligible low-rated issuers saw yields fall by about 72 basis points relative to comparable ineligible issuers. The higher gains from the MLF experienced by low-rated issuers, the authors hypothesize, imply that the MLF was seen as an indication of the Fed’s willingness to share credit risk by making loans available to struggling state and local governments.
Furthermore, Haughwout and co-authors show that in response to the improved muni market conditions and direct aid from the CARES Act, local governments eligible for the MLF retained 25% to 30% more service-providing employees, particularly in the education sector. High-rated government issuers recalled employees despite continued shutdowns—suggesting that the MLF option may have alleviated some of the uncertainty local governments faced at the start of the pandemic.
Huixin Bi and W. Blake Marsh of the Kansas City Fed investigate whether the increases in muni bond yields at the onset of the COVID crisis reflect overall liquidity risk (concern that a muni bond would be difficult to sell quickly without a substantial decline in price) or local credit risk (concern that counties with high COVID cases per capita would not be able to pay their debts on time). The authors compare yields on pre-funded bonds (which are essentially backed by Treasuries and so not much affected by credit risk concerns) to bonds that are not pre-funded. Movements in pre-refunded bond yields should reflect liquidity concerns, while changes in spreads between pre-refunded and not-pre-refunded bond yields should reflect credit risks. Observing that yields on both sets of bonds fell after Fed announcements, the authors conclude that policy interventions stabilized muni yields significantly by lowering liquidity risks, but didn’t immediate ease credit concerns—that is, worries that a prolonged economic downtown would make it difficult to governments to pay debt service on time.
Bi and Marsh also find that credit risks were an important component of short-term muni bond yields at the start of the pandemic. Following Fed interventions (which largely targeted short-term debt), credit concerns eased for short-term debt but became more pronounced for long-term debt.
The Fed did not intervene in the secondary market for muni bonds, as it did in the secondary market for corporate bonds. Yi Li and Xing (Alex) Zhou of the Federal Reserve Board and Maureen O’Hara of Cornell University argue that this lack of intervention prolonged fragility in the market for municipal bonds held by mutual funds. At the start of the crisis, secondary market dealers stopped buying and started selling muni bonds held by mutual funds, and continued to do so even after the Fed’s interventions stabilized the muni market—leaving a lingering spread of about 30 basis points, a “fire sale premium,” between bonds held by mutual funds and those that were not.
In the corporate bond market, however, which also saw large outflows from mutual funds at the start of the crisis, the announcement of the Fed’s Secondary Market Corporate Credit Facility offered reassurance to dealers that the Fed would purchase secondary market corporate bonds and stabilize liquidity in the market. Mutual fund outflows reversed, and soon returned to their pre-pandemic levels. With no such reassurance from the Fed, Li and co-authors argue, dealers in the muni market continued to sell bonds carrying mutual fund risks and the “fire sale premium” persisted.
The authors thank Jimena Ruiz Castro for research assistance on this post.