How the New Fed Municipal Bond Facility Capped Muni-Treasury Yield Spreads in the Covid-19 Recession

Abstract

For over two centuries, the municipal bond market has been a source of systemic risk, which returned early in the COVID-19 downturn when borrowing from securities markets became costly for many private and public entities, and some found it difficult to borrow at all. Indeed, just before the Fed announced its unprecedented intervention into the municipal (muni) bond market, spreads of muni over Treasury yields rose in line with the unemployment rate and appeared headed to levels not seen since the Great Depression, when real municipal gross investment plunged 35 percent below 1929 levels. To prevent a repeat, the Fed created the Municipal Liquidity Facility (MLF) to purchase newly issued, (near) investment grade state and local government bonds at normal ratings-based interest rate spreads over Treasury bonds plus a fee of 100 basis points, later reduced to 50 basis points. Despite a modest take-up, the MLF has effectively capped muni spreads at near normal levels plus the Fed fee and limited the extent to which interest rate spreads could have amplified the impact of the COVID pandemic. To establish the MLF the Fed needed Treasury indemnification against default losses. There are concerns about whether the creation of the MLF could undermine the efficiency of the bond market if the facility lasts too long and could induce moral hazard among borrowers. How the MLF will be unwound will affect these downside aspects and help answer the question whether the program's benefits exceed its costs.

A Political Economy of Fiscal Space: Political Structures, Bond Markets, and Monetary Accommodation of Government Spending Potential at Municipal, National, and International Levels

“…At multiple points since March 2020, central bank commitments to backstop bond markets have curtailed increasing costs for firms, sovereigns, and municipalities that issue bonds. (Arnold and Stubbington, 2020;Bordo and Duca, 2021) As these liquidity programs have expired, spreads on yields between economies with exorbitant privilege and those that lack it have grown to troubling degrees. (Rebaudo, 2021) The expiration of the DSSI has been followed by early defaults in EMEs on sovereign debt, despite persistent economic harm resulting from the Coronavirus pandemic.…”

“…(Fazzari, 1994;Bayoumi and Eichengreen, 1995;Marglin, 2021) Bond spreads between municipal bonds and US treasuries are countercyclical: they grow most during recessions. (Bordo and Duca, 2021) Though municipalities are unlikely to default, Bordo and Duca (2021) attribute the apparent skittishness of private bond holders to risk aversion.…”

“…Though the MLF only purchased a total of $17 billion in muni debt by the end of August 2020, the spread between municipal bonds and Treasury bills "stopped rising in the week when the Fed announced that it would set up MLF, well before the facility opened in late May." (Bordo and Duca, 2021, 13) Bordo and Duca (2021) argue that this rapid adjustment "suggests a strong 'backstop' effect similar to that of the Fed's corporate bond buying program on corporate spreads." (Bordo and Duca, 2021, 13) Preliminary figures from the Federal Reserve show that it conducted many more currency transfers to central banks that received swap lines between 2019 and 2020 than it did after the GFC.…”

The Municipal Liquidity Facility

“…They do not focus explicitly on the MLF, but find that long-term, low-rated bonds remained distressed beyond the various federal government interventions. Bordo and Duca (2021) further focus on the time series impact of the MLF announcement on yield spreads, and find that the MLF limited the growth of spreads by 5 to 8 percentage points. Li and Lu (2020) focus on the effects of shutdown announcements on offering yields (rather than trade prices) and find that initial offering yields increased in response to shutdowns and decreased following facility announcements.…”

The Impact of Covid-19 Related Policy Responses on Municipal Debt Markets

“…Our work is also somewhat related to Bordo and Duca (2021), which uses a monthly (or weekly) time series model of the tax-adjusted yield spread between the Baa-rated muni bond and the 10-year Treasury bond, from 1960 to early 2020, to examine the effect of MLF announcements. We also use tax-adjusted muni spreads to Treasuries in our analysis, but we exploit the entire daily term-structure for each state, and we evaluate a variety of policy interventions.…”