The Federal Reserve lowers the cost of borrowing for states and local governments

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The Federal Reserve announced Tuesday that it is cutting the cost of borrowing by half a percentage point for state and local governments that use it Municipal Liquidity Facility.

Municipalities looking to borrow from the Fed now have to pay between 1.0 and 5.4 percentage points above the benchmark interest rate for loans with a term of up to three years.

To date, the only state and local government that has used the facility has been Illinois. The financially troubled state sold $1.2 billion in debt to the Fed in June.

“Today’s changes will ensure that [municipal liquidity facility] continues to provide an effective hedge to help U.S. states and local governments manage the pandemic,” the Fed said in its statement.

The Fed’s move comes as do technical factors that have been supporting the market — particularly a wave of money of investors reinvesting capital from maturing bonds – is likely to ease. The supply is expected to increase in the coming weeks.

For a refresher, the Fed announced April It would set up a special purpose vehicle to buy up to $500 billion in municipal debt as part of its coronavirus relief effort.

When it launched the facility, the central bank said it would impose a “penalty fee”. or spread over benchmark interest rates — in contrast to its corporate bond facilities.

Prime tax-exempt municipal debt often yields less than government bonds because government bonds are taxable. For example, 10-year AAA-rated municipal bonds returned 0.60% on Tuesday, while 10-year government bonds closed with a yield of 0.64%.

So the running costs of the Fed facility remain much higher than market interest rates. Three-year AAA-rated municipal bonds returned 0.09% on Tuesday, according to Bloomberg data. The implied interest rate for a AAA-rated Muni using the Fed’s facilities — using benchmark interest rates in the derivatives markets and the new pricing plan — would be around 1.24%.

The Fed also reduced the amount of interest rate adjustment on taxable municipal debt compared to tax-exempt debt.

Given the onerous conditions and high cost of the Fed’s muni facility, strategists like Citigroup’s Vikram Rai are calling for more central bank support. That

iShares National Muni Bond Exchange Traded Fund

(MUB) is up 2.8% year to date, while the iShares iBoxx $ Investment

Grade corporate bond ETF

(LQD) is up 7.5%. (For comparison, the S&P 500 is up 3.2% year-to-date.)

However, the municipal bond market has posted decent returns this year amid concerns about what the pandemic could do to state and local government budgets. In a mid-July note, Tom Kozlik, head of municipal strategy and credit at Hilltop Securities, attributed this performance to widespread expectations that the Fed would eventually step in to expand its aid to municipal markets.

“To date, there has been extensive Federal Reserve support for other markets, and we do not believe that support for local governments … will match what has been provided in these other cases,” he wrote. “The Federal Reserve could and should do more now to prepare for a municipal market dislocation on liquidity concerns or credit fears. Investors might expect the Fed to act and gain ground relative to support from other markets because there is scope for the Fed to support the municipal market.”

write to Alexandra Scaggs at [email protected]

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