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Liquidity Matters: Munis earn HQLA distinction
May 29, 2018
Pop quiz for issuers: Should you care about the liquidity of muni bonds as an asset class?
If you answered “yes,” please read on and share your thoughts on our commentary below. If you answered “no,” please turn off your computer – you’ve failed the quiz.
We’ve spent the last couple of weeks talking about infrastructure projects and best practices for accessing low-cost capital in the municipal bond market. Today, we’re excited to discuss recently enacted legislation that will greatly enhance the liquidity of municipal bonds as an asset class.
Last week, President Trump signed into law the bipartisan-supported Economic Growth, Regulatory Relief and Consumer Protection Act (S.2155). As a result, many state and local governments – and other municipal issuers – are breathing a well-earned sigh of relief as the new law contains a provision to expand the universe of municipal bond buyers. This new law is a first step in the Trump-promised rollback of Dodd-Frank legislation, and S.2155 should make it easier to finance much-needed infrastructure projects.
Dodd-Frank, you likely remember, is the financial reform package that arose from the 2008 crisis. Among its many provisions was a requirement for banks to hold so-called High Quality Liquid Assets (or “HQLA”) to help them meet a Liquidity Coverage Ratio thereby enabling the bank to more efficiently manage periods of financial stress. Unfortunately, munis were not considered HQLA under Dodd-Frank initially. With S.2155 now in effect, municipal bonds join traditional corporate bonds among the ranks of the HQLAs that banks must hold.
This is incredibly important for issuers of all sizes. As investors, banks tend toward muni bonds that are rated in the “A” category or above. But with credit compression across the market, the bulk of issuers will be offering debt of at least that quality. That means that even though property & casualty insurers have curbed their buying in 2018 as a result of recent tax reform, new demand from banks due to the broader definition of HQLA should help overall muni performance.
Of course, it’s not exactly that black and white.
While I agree that the change to the treatment of municipal securities as a level 2B HQLA is a long-term positive for the market, I don’t think it’s an immediate catalyst for the municipal market to rally relative to other asset classes. Munis have other drivers of their relative performance, mostly from the lack of supply and positive flows this year. In my opinion, these should continue for the remainder of this year. These drivers will also make it hard to distinguish if there is any relative out-performance coming from bank portfolio purchases or reduction of their selling.
Banks buy and sell munis for reasons other than just liquidity treatment, making it even harder to distinguish what’s driving performance. Nonetheless, anytime you increase the depth and breadth of market participants it provides for more efficient markets. And we’re excited to see how muni rates and pricing responds.
Perhaps even more importantly, this legislation could be the signal from Washington that the muni market has been waiting for: a better understanding of the infrastructure crisis, that more tools for issuers are better, and the recognition of the municipal bond asset class as comparable in quality and liquidity with corporate bonds.
Kudos to the issuers and trade associations that have been pushing this boulder uphill for years. It’s a great example of how issuer groups like the GFOA and NAST can work with industry groups like SIFMA.