Navigating the evolving landscape of US municipal bonds
The United States of America (US) is home to the world's largest bond market - valued at over USD 51 trillion according to 2023 figures from the World Economic Forum. Within this large bond market, lie municipal bonds, which have become an increasingly important way for its states, cities and other governmental entities to fund public projects.
To find out more about the state of the municipal bond market in the US, we sat down with Matt Fabian, Partner at Municipal Market Analytics (MMA), an independent research and consulting group that publishes data, analysis, and commentary on the US municipal bond market to get his insights.
Bonds are usually repaid with revenues collected by the issuing government. For example, a city’s tax on the value of real property, a state’s income and sales taxes, or a utility’s water system usage fee.
The other 20% of municipal bonds were issued by competitive, largely not-for-profit enterprises - ranging from hospitals to recycling facilities - that more closely resemble US corporate bonds in terms of risk, structure, and disclosure. This 20% of the market represents the majority of municipal sector credit and default risk.
Few US municipal bonds have been issued to finance budget deficits, and almost none were sold to increase operating leverage or increase return on equity. In fact, US states and cities are reluctant borrowers at best, only raising capital through the public or private markets when their own cash is insufficient to afford a needed infrastructure project, and they look to retire their debt as quickly as possible.
Nearly all US municipal bonds are issued in a series of annual maturities that, together, replicate self-amortising securities seen in other markets. Most municipal bonds have optional call features that activate ten years after issuance, allowing borrowers to refinance or accelerate their repayment of principal.
The municipal market’s main complication, however, is its high degree of issuer and security heterogeneity. Only states exist in the US Constitution, which means that nearly all of the 37,000 current municipal bond borrowers are wholly owned subsidiaries of their states, created and operated pursuant to 50 different sets of state laws.
There are commonalities here. For example, most US cities and counties use property taxes to fund basic safety and education operations and sell bonds backed by a pledge to raise related tax rates as needed to pay debt service, but details can vary greatly from state to state.
Finally, we have the tax exemption. About 85% of all outstanding municipal bonds, and annual bond issuance, carry coupons whose income is exempt from the US federal income tax and, mostly, any state or local income taxes in the state where they are issued.
Bonds qualify for tax-exempt status so long as their issuer is a governmental entity and the bond proceeds are not given to a private party or invested for arbitrage, with some exceptions.
Because US municipal bonds are the only securities eligible for this income tax exemption, and because the outstanding amount has remained at approximately USD 4 trillion for the last fifteen years, interested investors have faced a chronic shortage of bonds to buy.
Scarcity has allowed issuers broad discretion in how and what they borrow, resulting in a much smaller, more customised, and inherently less liquid bond market than what typically characterises the US corporate or international bond markets.
The 15% (~USD 600 billion) of outstanding municipal bonds that are fully taxable are similar to tax-exempt bonds in terms of issuers, security pledges, and related credit risk but are frequently structured to appeal to corporate or non-US bond buyers.
Larger issues can be non-callable or feature make whole calls and similar covenants, may carry corporate ticker symbols, and are more likely to provide independent third-party verification of green or similar impact credentials.
On the other hand, even fully index-eligible taxable US municipal bonds are rarely traded as frequently or robustly when compared to US corporate bonds, undermining secondary market liquidity and price discovery. In exchange, borrowers typically pay somewhat higher risk-adjusted yields to their lenders.
Higher inflation expanded state and local tax collections even as many governments deployed some form of fiscal austerity.
The net effect was a rise in municipal credit quality and slower governmental borrowing, compounding product scarcity challenges for municipal investors and catalysing institutional demand for long duration securities.
However, once the US Federal Reserve began raising interest rates, municipal bond prices fell sharply, causing mark-to-market losses for many investors. The latter notably included some domestic banks that were already facing large market value losses from commercial real estate exposure.
In 2024, with the Federal Reserve intending to begin cutting its target rate, municipal bond prices have mostly stabilised, and many anticipate a rally later this year.
A surge of investment into lower cost retail platforms such as separately managed accounts (SMAs) by high-net-worth individuals has begun to widen term spreads as securities favored by these buyers (e.g., higher rated, shorter maturity, tax-exempt bonds) outperform longer duration positions. Note that taxable municipal bond issuance has dropped sharply with higher reference yields on US Treasury securities.
Those defaults amount to just 3% of the outstanding municipal bond universe. In the last six years, annual municipal bond payment defaults have not exceeded USD 6 billion or 0.2% of total sector par.
An important distinction must be made here - US municipal bond default risk clusters by security type. The current default rate (or, the percent of outstanding par currently involved in an uncured payment default, regardless of when that default began) is very low for traditionally high grade, governmental sectors, inclusive of taxable bonds in those sectors.
Hewing to historically “safe” sectors within the US municipal universe is critically important to portfolio performance. For example, state and local general obligation bonds - which account for ~USD 1.2 trillion of outstanding par - have a 0.00% current default rate at present, while water and sewer revenue bonds have a 0.02% current default rate.
US state and local governments’ historically low default rates reflect the monopolistic tax or rate setting power of the borrower, those borrowers’ strong incentives for keeping bond ratings as high as possible, and the self-amortising nature of the debt itself, which minimises issuer refinancing risk.
Traditional high yield sectors, where repayment depends on the success of a less-governmental competitive enterprise, have current default rates as high as 10.77% for senior living borrowers, such as assisted living facilities and continuing care retirement centers, or 2.19% for project finance transactions that use a for-profit borrower at their core.
Note that the US federal government only rarely provides an enhancement or backstop to the municipal borrower’s pledged security and states seldom do the same for local governments within their boundaries. US municipal bond borrowers usually stand alone in their repayment responsibilities.
A major exception to the latter regards local public school districts, which commonly have access to state programmes that enhance or otherwise secure the repayment of their bonds. These are highly state-specific and may provide direct guaranties in states such as Texas and Oregon, intercept programmes that capture district operating aid for bond payments in states such as New Jersey and Pennsylvania, or an enhanced legal commitment of tax collections to debt service which is the case in California.
There are also two private corporations operating as monoline bond insurers. Build America Mutual (BAM) and Assured Guaranty will sell bond insurance policies to bond issuers that guarantee the payment of debt service in the event the borrower fails to do so. Both companies’ claims paying abilities are rated in the AA category, and insured bonds will carry this rating. Bond insurance policies cannot be cancelled until bonds mature and are unconditional, even in cases of fraud on the part of the borrower.
This means related creditors can be treated as unsecured in event of a borrower bankruptcy, as handled pursuant to chapter 9 of the US bankruptcy code.
However, US states, as sub-sovereign entities, do not have access to federal bankruptcy protection of any kind. So, state general obligation bonds - regardless of state name or geographic region - present a solid credit profile and what should be an acceptable legal structure for international investors.
In contrast, essential purpose utilities - for municipal water and sewer systems or for public electric systems or toll roads - do have formal security pledges and trust indentures, as do so-called special tax transactions, whereby a state or city specifically encumbers one or more tax items to secure a borrowing program.
The latter can include bonds backed by sales taxes or income taxes or a host of smaller taxes such as motor vehicle taxes, fuel taxes, hotel taxes, etc. All of these traditionally feature very low risk of payment default, in particular among rated securities.
State, and sometimes local governments also issue a form of mortgage-backed securities, in which bond proceeds are used to originate loans to first-time homebuyers meeting income restrictions. These securities can be enhanced with US federal mortgage guaranty programmes (through GNMA or FNMA) or may be backed by aggregated repayments of the underlying mortgage loans. These bonds rarely default but feature prepayment and call risks similar to taxable MBS.
Finally, universities and hospitals both issue taxable bonds on a regular basis and can be excellent credit risks so long as the borrower is large and sophisticated. Smaller and rural universities and hospitals, by contrast, can present a higher-than-typical credit risk over the life of the bond.
However, away from a few select cases, most notably the New York City Metropolitan Transportation Authority and Washington DC Water, state and local borrowers in the US have not often chosen to formally label their bond issues as green, and independent third-party verification of green or social credentials is even more rare.
This reflects the generic scarcity of tax-exempt paper and the limited audience of investors willing to pay a higher price for a labeled bond versus an unlabeled one.
There is a somewhat larger supply of labeled social bonds, most of these issued to finance (and ultimately repaid by) subsidised affordable housing projects. There is also an outstanding universe of self-labeled “green” project finance bonds - mostly enhanced recycling facilities - that have seen a fairly severe rate of payment default and should be avoided by non-speculative investors.
Income-tax-paying buyers will typically offer a higher price for a given security. This is less the case with taxable municipal securities, where a slight advantage lies instead with investors willing to understand underlying securities and/or absorb the incremental liquidity deficiency in outstanding bonds.
Also, tax-exempt municipal bonds are subject to punitive US federal tax treatment when purchased at a discount greater than 1/4th of a point per year left before maturity. This so called de minimus discount rule should be considered carefully by investors interested in carrying longer maturity, lower coupon securities.
To find out more about the state of the municipal bond market in the US, we sat down with Matt Fabian, Partner at Municipal Market Analytics (MMA), an independent research and consulting group that publishes data, analysis, and commentary on the US municipal bond market to get his insights.
What exactly is a municipal bond , and how does it differ from other types of bonds available in the market?
In the US, about 80% of the USD 4 trillion in outstanding municipal bonds were issued by state and local governments, or by government-owned utilities, to finance public infrastructure projects like schools and roads.Bonds are usually repaid with revenues collected by the issuing government. For example, a city’s tax on the value of real property, a state’s income and sales taxes, or a utility’s water system usage fee.
The other 20% of municipal bonds were issued by competitive, largely not-for-profit enterprises - ranging from hospitals to recycling facilities - that more closely resemble US corporate bonds in terms of risk, structure, and disclosure. This 20% of the market represents the majority of municipal sector credit and default risk.
Few US municipal bonds have been issued to finance budget deficits, and almost none were sold to increase operating leverage or increase return on equity. In fact, US states and cities are reluctant borrowers at best, only raising capital through the public or private markets when their own cash is insufficient to afford a needed infrastructure project, and they look to retire their debt as quickly as possible.
Nearly all US municipal bonds are issued in a series of annual maturities that, together, replicate self-amortising securities seen in other markets. Most municipal bonds have optional call features that activate ten years after issuance, allowing borrowers to refinance or accelerate their repayment of principal.
The municipal market’s main complication, however, is its high degree of issuer and security heterogeneity. Only states exist in the US Constitution, which means that nearly all of the 37,000 current municipal bond borrowers are wholly owned subsidiaries of their states, created and operated pursuant to 50 different sets of state laws.
There are commonalities here. For example, most US cities and counties use property taxes to fund basic safety and education operations and sell bonds backed by a pledge to raise related tax rates as needed to pay debt service, but details can vary greatly from state to state.
Finally, we have the tax exemption. About 85% of all outstanding municipal bonds, and annual bond issuance, carry coupons whose income is exempt from the US federal income tax and, mostly, any state or local income taxes in the state where they are issued.
Bonds qualify for tax-exempt status so long as their issuer is a governmental entity and the bond proceeds are not given to a private party or invested for arbitrage, with some exceptions.
Because US municipal bonds are the only securities eligible for this income tax exemption, and because the outstanding amount has remained at approximately USD 4 trillion for the last fifteen years, interested investors have faced a chronic shortage of bonds to buy.
Scarcity has allowed issuers broad discretion in how and what they borrow, resulting in a much smaller, more customised, and inherently less liquid bond market than what typically characterises the US corporate or international bond markets.
The 15% (~USD 600 billion) of outstanding municipal bonds that are fully taxable are similar to tax-exempt bonds in terms of issuers, security pledges, and related credit risk but are frequently structured to appeal to corporate or non-US bond buyers.
Larger issues can be non-callable or feature make whole calls and similar covenants, may carry corporate ticker symbols, and are more likely to provide independent third-party verification of green or similar impact credentials.
On the other hand, even fully index-eligible taxable US municipal bonds are rarely traded as frequently or robustly when compared to US corporate bonds, undermining secondary market liquidity and price discovery. In exchange, borrowers typically pay somewhat higher risk-adjusted yields to their lenders.
Can you provide insights into the current landscape of municipal bonds in the USA? What are the latest trends?
During the pandemic, the US federal government provided substantial direct aid to state and local governments that included both operating assistance and capital project funding.Higher inflation expanded state and local tax collections even as many governments deployed some form of fiscal austerity.
The net effect was a rise in municipal credit quality and slower governmental borrowing, compounding product scarcity challenges for municipal investors and catalysing institutional demand for long duration securities.
However, once the US Federal Reserve began raising interest rates, municipal bond prices fell sharply, causing mark-to-market losses for many investors. The latter notably included some domestic banks that were already facing large market value losses from commercial real estate exposure.
In 2024, with the Federal Reserve intending to begin cutting its target rate, municipal bond prices have mostly stabilised, and many anticipate a rally later this year.
A surge of investment into lower cost retail platforms such as separately managed accounts (SMAs) by high-net-worth individuals has begun to widen term spreads as securities favored by these buyers (e.g., higher rated, shorter maturity, tax-exempt bonds) outperform longer duration positions. Note that taxable municipal bond issuance has dropped sharply with higher reference yields on US Treasury securities.
How safe are municipal bonds compared to other investment options? Are there any measures in place to protect investors?
US municipal bond default rates are low in both relative and nominal terms. In the last sixteen years, an aggregate USD 120 billion of municipal bond principal has been associated with a payment default, with just over half of that connected to Puerto Rico, a US Territory that has been in a special form of federal bankruptcy since 2017.Those defaults amount to just 3% of the outstanding municipal bond universe. In the last six years, annual municipal bond payment defaults have not exceeded USD 6 billion or 0.2% of total sector par.
An important distinction must be made here - US municipal bond default risk clusters by security type. The current default rate (or, the percent of outstanding par currently involved in an uncured payment default, regardless of when that default began) is very low for traditionally high grade, governmental sectors, inclusive of taxable bonds in those sectors.
Hewing to historically “safe” sectors within the US municipal universe is critically important to portfolio performance. For example, state and local general obligation bonds - which account for ~USD 1.2 trillion of outstanding par - have a 0.00% current default rate at present, while water and sewer revenue bonds have a 0.02% current default rate.
US state and local governments’ historically low default rates reflect the monopolistic tax or rate setting power of the borrower, those borrowers’ strong incentives for keeping bond ratings as high as possible, and the self-amortising nature of the debt itself, which minimises issuer refinancing risk.
Traditional high yield sectors, where repayment depends on the success of a less-governmental competitive enterprise, have current default rates as high as 10.77% for senior living borrowers, such as assisted living facilities and continuing care retirement centers, or 2.19% for project finance transactions that use a for-profit borrower at their core.
Note that the US federal government only rarely provides an enhancement or backstop to the municipal borrower’s pledged security and states seldom do the same for local governments within their boundaries. US municipal bond borrowers usually stand alone in their repayment responsibilities.
A major exception to the latter regards local public school districts, which commonly have access to state programmes that enhance or otherwise secure the repayment of their bonds. These are highly state-specific and may provide direct guaranties in states such as Texas and Oregon, intercept programmes that capture district operating aid for bond payments in states such as New Jersey and Pennsylvania, or an enhanced legal commitment of tax collections to debt service which is the case in California.
There are also two private corporations operating as monoline bond insurers. Build America Mutual (BAM) and Assured Guaranty will sell bond insurance policies to bond issuers that guarantee the payment of debt service in the event the borrower fails to do so. Both companies’ claims paying abilities are rated in the AA category, and insured bonds will carry this rating. Bond insurance policies cannot be cancelled until bonds mature and are unconditional, even in cases of fraud on the part of the borrower.
Are there specific sectors or regions within the US municipal bond market that appeal to European and international investors?
One challenge for international investors looking at the US municipal market is that the largest (and statistically safest) sector - state and local general obligation bonds - typically carry few corporate-style security pledges and often do not have trust indentures or loan agreements.This means related creditors can be treated as unsecured in event of a borrower bankruptcy, as handled pursuant to chapter 9 of the US bankruptcy code.
However, US states, as sub-sovereign entities, do not have access to federal bankruptcy protection of any kind. So, state general obligation bonds - regardless of state name or geographic region - present a solid credit profile and what should be an acceptable legal structure for international investors.
In contrast, essential purpose utilities - for municipal water and sewer systems or for public electric systems or toll roads - do have formal security pledges and trust indentures, as do so-called special tax transactions, whereby a state or city specifically encumbers one or more tax items to secure a borrowing program.
The latter can include bonds backed by sales taxes or income taxes or a host of smaller taxes such as motor vehicle taxes, fuel taxes, hotel taxes, etc. All of these traditionally feature very low risk of payment default, in particular among rated securities.
State, and sometimes local governments also issue a form of mortgage-backed securities, in which bond proceeds are used to originate loans to first-time homebuyers meeting income restrictions. These securities can be enhanced with US federal mortgage guaranty programmes (through GNMA or FNMA) or may be backed by aggregated repayments of the underlying mortgage loans. These bonds rarely default but feature prepayment and call risks similar to taxable MBS.
Finally, universities and hospitals both issue taxable bonds on a regular basis and can be excellent credit risks so long as the borrower is large and sophisticated. Smaller and rural universities and hospitals, by contrast, can present a higher-than-typical credit risk over the life of the bond.
With an increasing focus on sustainable and responsible investing, how do green and social bonds fit within the US municipal market?
Depending on a lender’s specific investment policy, many or most US municipal bonds could qualify as “green” or “social impact bonds” as the majority have been issued for public or social infrastructure - many to alleviate poverty, expand education, and improve the sustainability of public facilities.However, away from a few select cases, most notably the New York City Metropolitan Transportation Authority and Washington DC Water, state and local borrowers in the US have not often chosen to formally label their bond issues as green, and independent third-party verification of green or social credentials is even more rare.
This reflects the generic scarcity of tax-exempt paper and the limited audience of investors willing to pay a higher price for a labeled bond versus an unlabeled one.
There is a somewhat larger supply of labeled social bonds, most of these issued to finance (and ultimately repaid by) subsidised affordable housing projects. There is also an outstanding universe of self-labeled “green” project finance bonds - mostly enhanced recycling facilities - that have seen a fairly severe rate of payment default and should be avoided by non-speculative investors.
What tax implications should European and international investors be aware of when investing in US municipal bonds?
To be clear, investors not subject to the US federal or state income tax face a disadvantage in the after-tax yield of the tax-exempt bonds they would purchase.Income-tax-paying buyers will typically offer a higher price for a given security. This is less the case with taxable municipal securities, where a slight advantage lies instead with investors willing to understand underlying securities and/or absorb the incremental liquidity deficiency in outstanding bonds.
Also, tax-exempt municipal bonds are subject to punitive US federal tax treatment when purchased at a discount greater than 1/4th of a point per year left before maturity. This so called de minimus discount rule should be considered carefully by investors interested in carrying longer maturity, lower coupon securities.
