Muni Week in Review: Yields Just Keep Going Up

Markets Associated Press

After hitting a one-year high following Donald Trump's surprise White House victory, municipal bond yields climbed even higher this week.

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The yield on the 10-year muni bond was 2.525 percent as of 5 p.m. Eastern time on Friday, according to the AP Municipal Bond index. As recently as mid-August, it was below 1.8 percent.

Yields on the short-term two-year municipal bond also spiked again, landing at 1.187 percent. Just two weeks ago, the two-year yield was 0.93 percent. The yield on the 30-year muni finished the week at 3.277 percent.

While most experts had predicted that stocks would drop after a Trump victory, it was the bond market that cratered last week. Many investors believe that Trump's plans to stoke the economy will result in inflation, higher debt and faster-than-expected interest rate increases, all of which would weigh on the price of bonds. In response, they yanked their money out of bonds, causing prices to tank and yields to rise. Bond yields and prices move in opposite directions.

Municipal bonds are facing many of the same challenges as Treasurys, along with a significant additional uncertainty: tax reform. President-elect Trump has made clear that he will try to lower tax rates, especially for high earners. Should that happen, it would decrease the appeal of tax-exempt holdings such as municipal bonds. That, in turn, would force muni issuers to adjust their prices to attract buyers and increase borrowing costs for state and local governments, says Peter Hayes, head of BlackRock's municipal bonds group.

In response to all those potential negatives, investors dumped muni bonds last week, creating the largest weekly sell-off since 2013. The largest municipal bond exchange-traded fund, the iShares National Muni Bond ETF, fell 1.1 percent this past week.

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Investors have always demanded higher yields for holding long-term bonds, which are riskier than their short-term rivals. The gap, or spread, in yields between short- and long-term muni bonds has also gotten larger following the election. The spread between two- and 10-year muni bonds was 1.338 percentage points, as of Friday evening. Shortly before the election, it was only 1.126 percentage points.

In other election-related muni bond news:

— Policy changes: Winners and losers

A report released this week by S&P Global Ratings outlined some of the regulatory policies that have the potential to hurt — and help — the credit landscape for states.

Many states now rely heavily on federal funding to prop up their finances. "It's been a very strange economic recovery from a state tax revenue standpoint," says S&P credit analyst Robin Prunty, "We've had a lot of downgrade activity, and that's not a pattern we typically see in a recovery period."

States currently receive nearly $370 billion in grants for Medicaid, which could be rolled back with changes in health care policy, the report notes. That would damage the credit outlook for some states. Not-for-profit hospitals and public housing could also face challenges.

On the other hand, lighter regulations for power and water utilities may lower the cost to states to provide those services.

— California voters weigh in

California ballots this year contained a slew of initiatives that will have a significant impact on state credit and bond issuance in the Golden State.

Voters approved a proposition to extend 2012's tax increases on the wealthiest Californians by 12 years. The measure, which hiked income tax rates by 1 percentage point to 3 percentage points for families earning more than about half a million dollars a year, has been credited with helping California emerge from a budget crisis following the Great Recession.

Another proposition to approve $9 billion in bonds for school and community college construction projects was also approved. California Gov. Jerry Brown had argued against the measure, saying it favored more affluent communities.

Finally, voters rejected a measure that would have required voter approval on revenue bonds totaling more than $2 billion that would be used for public infrastructure projects.