After ringing up more than $1.1 billion in new investments last month, inflows to bond funds have slowed in February after strong recent economic data stirred concerns that the U.S. Federal Reserve will raise interest rates higher for longer.
Markets had a hunch the Fed could pause its campaign of rate increases and even cut rates this year. The news that inflation and consumer spending remain strong has shot down those expectations; the central bank is now seen as likely to raise its key rate by at least a quarter point next month.
Rates on municipal bonds tend to move in tandem with treasury securities.
Therefore, if the Fed does boost its rate, newer bonds paying higher interest rates will be more attractive than older ones paying less. As a result, investors are waiting for the Fed’s next move.
Municipal bonds are especially attractive investments in their asset class because the interest they pay usually is exempt from both state and local taxes.
A tax-free 5-percent yield on a muni bond is equivalent to a taxable yield of 8 percent for people in the top tax bracket, according to Nuveen Asset Management.
However, investors remain uncertain of the Fed’s plans as well as their effect on the overall economy.
Since mid-December, debt maturing in a year has carried higher interest rates than bonds maturing in three years, according to ICE Data Services.
That has not happened for a two-month stretch since at least 2007, market professionals told The Wall Street Journal.
Such an inversion in government securities tends to signal an economic slowdown; in muni bonds, it means investors are confused, Matt Fabian, a partner at Municipal Market Analytics, said to the WSJ.
“All this volatility has bent the muni market,” he added.
That volatility includes uncertainty over the U.S. Congress’s willingness to lift the debt ceiling.
Republicans have conditioned their support for the move on deep federal spending cuts, which could reduce federal aid to cities and towns.
In addition, some money managers have cut back bond purchases because they believe bond prices are too high, and yields too low, as the threat of recession remains.
The risk-reward ratio is especially thin for the roughly $500 billion in bonds to fund nonessential projects such as museums and charter schools, the WSJ noted.
“In our view, you’re not getting paid enough to take on that risk right now,” Baird Advisors portfolio manager Duane McAllister said in a WSJ interview.
TRENDPOST: Making a bad situation worse, municipalities already are facing excruciating budget dilemmas from rising costs, higher interest rates, added debt from extra health care costs incurred during the COVID War, and, for some, the prospect of falling property tax revenue as commercial landlords challenge their properties’ value assessments. (See “As Forecast: Office Building Bust Begins to Bite,” 20 Dec 2022.)