The Imprint of Monetary Policy on Munis

As the 2021 fiscal year officially gets underway for many municipal issuers, state and local governments have begun to take stock of the economic toll of COVID-19.

So far, the results aren’t pretty.

Some states are predicting shortfalls ranging from 10%-20% of their annual budgets, which have already paved the way for painful fiscal austerity measures. And with many states dialing back economic reopening plans, the economic pain will likely be felt for some time to come.

An unprecedented policy response

Fortunately, the U.S. Federal Reserve has stepped in with an unprecedented policy response. In order to enhance market liquidity, the Fed is extending credit to new corners of the capital markets, including municipal bonds. While the Fed’s actions have helped restore confidence in the municipal markets, investors must now contend with the effects these policy responses are having on market dynamics.

Fed lending facilities expand to include munis

With backing from Congress and approval by the U.S. Treasury, the Federal Reserve Board in March reincarnated a number of lending facilities created during the 2008 financial crisis, while also creating an entirely new mechanism for enhancing municipal market liquidity.

  1. The Primary Dealer Credit Facility (PDCF) provides term loans to primary dealers in order to facilitate smooth market functioning. Unlike the last PDCF, which operated between 2008 and 2010 and consisted solely of overnight loans, the latest iteration offers funding for up to 90 days.
  2. The Commercial Paper Funding Facility (CPFF) allows the Fed to purchase municipal issues with maturities ranging from one week to 270 days. The aim of the CPFF, which also had a previous life in the throes of the 2008-2009 recession, is to enhance the liquidity of the short-term lending market by providing a backstop to issuers of commercial paper.
  3. The Municipal Liquidity Facility (MLF) was newly established in March to lend up to $500 billion directly to eligible municipal issuers, with maturities of up to 36 months. These include investment grade-rated states, cities with more than 250,000 residents, and counties with populations of more than 500,000 residents. More recently, the Fed expanded issuer eligibility to include two revenue bond entities per state, which opens the door to public transit agencies such as the New York Metropolitan Transportation Authority.

While these Fed facilities have been effective in bringing down short-term yields and improving market sentiment, they could also affect how investors deploy their capital.