Note: Standard errors are shown in parentheses.
_ Table 1: Regression Model of Excess Spread on March 20 Neither an increase in the share of industries affected by COVID-19 (implying lower tax revenues) nor an increase in the COVID-19 incidence rate (implying higher spending on health care), is associated with higher spreads on March 20, just prior to the Federal Reserve’s intervention. Table 1 shows that the effects of three state-specific fundamentals-the share of industries affected by COVID-19, the COVID-19 incidence rate (cases per 100,000 people), and the rainy day fund balance as a share of total expenditures-are not statistically significant, suggesting they cannot explain the excess spreads. Using a regression model, we find that investors likely acted due to liquidity concerns, not state-specific credit risks.
If the excess spread cannot be explained by these factors, investors likely acted on liquidity concerns and without regard to increasing credit risks. _ If the excess spread can be explained by a combination of the issuer state’s exposure to COVID-19 and its prevailing fiscal position, investors likely acted due to fears of credit risk. To disentangle the roles of liquidity and credit risks in driving the late March rise in municipal bond yields, we examine the “excess spread” that investors price into municipal bonds over and above their historical measurable credit risk. Indeed, the greater increase for shorter-maturity bonds may reflect the fact that states extended their tax payment deadlines, thereby increasing their short-term default probabilities (Haughwout, Hyman, and Lieber 2020). The COVID-19 pandemic is likely to reduce both the tax base and revenue streams for the state and local governments that issue municipal bonds, increasing credit risk in the market. On the other hand, investors may have been motivated to sell to reduce their exposure to credit risk. To the extent investors were concerned about their future ability to sell their holdings, they may have sought a first-mover advantage in selling quickly. Municipal bonds are already fairly illiquid because they are thinly traded. On one hand, investors may have been driven to sell their bonds due to liquidity concerns. Chart 1: Municipal Bond Yield to Treasury Yield RatioĪlthough the expanded MMLF appears to have been effective in driving down the municipal bond ratio, it is not clear why municipal bond yields spiked in the first place.
_ The municipal bond ratio subsequently fell across all maturities (orange line). Specifically, the Fed expanded its Money Market Mutual Fund Liquidity Facility (MMLF) in late March to accept certain municipal bonds as eligible loan collateral. The Federal Reserve acted quickly in its role as “lender of last resort” to alleviate price pressures in the bond market. However, as the pandemic worsened, municipal money fund outflows increased and money managers sold their bond holdings at a rapid rate, leading prices to fall and the municipal bond ratio-the ratio of municipal bond yields to comparable Treasury yields-to increase.Ĭhart 1 shows that the municipal bond ratio rose sharply in March (green line) relative to late January (blue line), especially for short maturity bonds.
Most of the nearly $4 trillion of outstanding municipal bonds are held by mutual funds, which allow institutional and retail investors to diversify their portfolios (Gillers and Banerji 2020). This slowdown put stress on the municipal bond market, which provides funding for state and local governments, schools, and utility districts. State-issued quarantine and shelter-in-place orders to address the spread of COVID-19 dramatically slowed economic activity in March.
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