Jim Reber: Supply chain histrionics

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To start the year, here are my thoughts on the municipal bond market.

By Jim Reber, ICBA Securities

The most prominent, by far, comment I heard from ICBA members in the second half of 2021 was that they weren’t sure where their income is going to come from in 2022.

This was mainly the result of two variables acting independently but in concert. The first is that community banks benefited greatly from both rounds of the Small Business Administration’s (SBA) Paycheck Protection Program (PPP), and no successor is on the horizon. The second was the continued margin pressure resulting from the Federal Reserve’s aggressive “accommodation” in its monetary policy, which for most of the past two years has left little room for net interest margins that community bank managers would be proud of.

Several factors may be in play in 2022 that could provide some opportunity to create what capital market analysts refer to as “quality earnings.” These, in a nutshell, are net margins from traditional means, namely core lending and borrowing. The most prevalent portfolio manager wish is that interest rates tick higher, and it’s well documented that community banks are poised for a rate rally. Another hope is that traditional loan demand picks up, possibly fueled by all the unspent stimulus money and the dislodging of supply chain logjams. Supply and demand dynamics are in play in the financial markets as well.

Munis matter

You may recall seeing in this column over the years that municipal bonds are a driver of performance in community bank bond portfolios. There may be temporary episodes of “dislocation”—bond-analyst speak for yield spikes—but, overall, the muni market has been remarkably stable in the past 30 years. If it had ever been put to the test, it was in 2020. Both Moody’s and Standard & Poor’s placed the state and local municipal bond sectors on “outlook negative” in March 2020, only to restore them to “outlook stable” a year later. Ratings upgrades in 2021 far outnumbered 2020’s downgrades.

Even better, in spite of what appears to be improving credit metrics, yield spreads for most high-quality municipal bonds remain attractive on an historical basis. For the past couple of months, a bank could purchase a 10-year AAA-rated muni at a raw yield (i.e., before the tax effect is factored in) of around 90% of a like maturity treasury. That is well above the old benchmark of around 75% that was in place for much of the past decade. It’s also in spite of supply issues, which we’ll learn about soon.

Demand on the rise

The term “crossover buyer” has evolved in the past 10 years or so. At one point, it was a reference to retail investors, who hold around two-thirds of the entire $3.9 trillion muni market. It now can include banks that traditionally bought the small subset of the market known as Bank Qualified (BQ) munis, which provided a tax break for financial institutions (see my March 2021 column). It can also include nonbanks like mutual funds, central banks and even—gasp—credit unions, thanks to the growth in the supply of taxable munis.

2022 could be a year that municipal bonds perform well. Rising rate environments … coupled with solid bank earnings and bolstered by healthy demand and limited supply, seem to have this important investment sector positioned well.

Generically, then, crossover buyers are those that are outside their traditional muni lanes, and in 2022, that will mean most everyone.

As to why munis are so highly coveted, it’s almost a case of “what’s not to like?” As long as credit quality holds up, which seems to be the situation currently, you’ve got a number of factors working for you, such as:

  • good liquidity
  • a reasonable yield compared with alternatives
  • limited price volatility
  • a steep yield curve

Currently, about 28% of community bank portfolios are made up of municipal bonds. Given that portfolios have grown in size by more than 50% in the past 18 months, bank buying alone has helped push demand to record levels.

Supply struggles to keep up

Don’t believe the headline numbers that there was near-record muni issuance in 2021. Yes, various date sources pegged the total around $480 billion, which is a big number. However, refinancings of outstanding issues remain at high levels, and “new money” issues are only about 65% of the total. More to the point, the $3.9 trillion number for the entire market has been impressively unchanged since 2009.

I say “impressive” in the sense that the financial managers of state and local governments have not been net borrowers for more than a dozen years. That’s in nominal terms; even more notable is that inflation alone would have pushed borrowings around 22% higher, all things remaining equal. And things are not equal, as the U.S. population is now about 7% greater than in 2009.

At its outset, 2022 could be a year that municipal bonds perform well. Rising rate environments, which usually accompany a flattening yield curve, coupled with solid bank earnings and bolstered by healthy demand and limited supply, seem to have this important investment sector positioned well. Munis will play a critical role in many community banks’ income results in the coming year.

Economic Outlook webinar

ICBA Securities’ exclusive broker Vining Sparks will once again host quarterly webinars that discuss the state of the economy, monetary policy and interest rate trends. Economists Craig Dismuke and Dudley Carter will kick off the series on Jan. 11 at 10 a.m. Central. To register, visit viningsparks.com

Jim Reber, CPA, CFA (jreber@icbasecurities.com), is president and CEO of ICBA Securities, ICBA’s institutional, fixed-income broker-dealer for community banks