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Municipal bonds are off to their worst start since 2011.

The early-year bond rout has dragged returns on the S&P Municipal Bond Index to minus 1.1% through Jan. 20, counting price changes and interest payments. The loss is an early sign that rising interest rates could make 2022 rockier than last year, when federal stimulus and elevated demand from homebound savers led to record low volatility and historically high prices. 

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Now investors are eyeing those prices more warily. Muni bond mutual and exchange-traded funds took in a net $830 million through Jan. 19, compared with $6.1 billion last year, according to Refinitiv Lipper. After Fed officials indicated they could lift short-term rates sooner than expected, muni yields jumped alongside Treasury yields, with 10-year AAA muni yields rising to 1.28% Jan. 20 from 1.03% Dec. 30, according to Refinitiv Municipal Market Data. Yields rise as bond prices fall.

State and local governments issue long-term debt in the roughly $4 trillion muni market, typically for capital projects such as highways and schools. Affluent investors prize munis because most throw off interest that is exempt from federal, and often state, taxes. 

But rising interest rates make outstanding bonds with comparatively lower yield less attractive, a worrisome possibility for anyone holding or buying muni debt. They also increase borrowing costs for state and local governments, whose tax-exempt borrowing fell to $9.2 billion this year through Jan. 20, a four-year low. The city of Greenwich, Conn., issued one-year debt at a net interest cost of 0.21% in the first week of January, up from 0.12% last January, according to Comptroller Peter Mynarski.

Some analysts also expect a drop off in demand for munis this year because of an anticipated slowdown in household savings, which increased during the pandemic, especially for the wealthy. 

The appetite for tax-exempt debt has long exceeded yearly issuance. The imbalance grew over the past year as higher-income Americans moved savings and the windfalls they got from blockbuster stock gains into municipal bonds. Analysts don’t expect those inflows to continue at the same pace this year. 

Creditworthiness could become more of an issue for some struggling cities in 2022 as they continue to spend down waves of federal pandemic aid. That aid, as well as tax revenues from purchases made with stimulus checks and stimulus-fueled stock gains, helped strengthen municipal credit in 2021, when public-finance upgrades slightly outpaced downgrades by Fitch Ratings. In 2020, Fitch did 80% more downgrades than upgrades, as the pandemic shut down local economies and strained services. 

Sustained inflation also could aggravate credit woes, because it would drive up the cost of government projects, services and cost-of-living adjusted retirement benefits, some analysts said.  

“How good is muni credit if the baseline of the budget has to go up 5%” several years in a row? asked Adam Stern, co-head of research at Breckinridge Capital Advisors. “Some places can handle it, other places probably can’t.” 

Default is extremely rare in the municipal market. But debt issued by strapped borrowers tends to fall in price under adverse financial conditions, driving down the value of investors’ portfolios and creating a dilemma for those who want to cash out. 

In some ways, the increased potential for volatility in 2022 marks a return to a more familiar investment environment after a year of unusual calm, which followed a year of Covid-related upheaval. After a liquidity crisis in 2020 in the early days of the pandemic, the muni market in 2021 had a record 113 days when yields on AAA intermediate maturity bonds didn’t change from the day before, according to data from Municipal Market Analytics.

The year “2020 was abnormal in terms of volatility,” said Michael Zezas, municipal strategist and head of U.S. public policy research at Morgan Stanley. “2021 was abnormally calm. This is a return to normal.”

Write to Heather Gillers at [email protected]

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Source: WSJ

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