Muni Risks Papered Over by Federal Aid Threaten to Reappear

The influx of federal aid to U.S. municipal-bond issuers has papered over longstanding credit risks that threaten to come back to bite investors when the relief runs dry.

States, local governments and other borrowers are receiving $350 billion through the American Rescue Plan, a short-term infusion meant to cover revenue lost to the pandemic or offset its economic toll. The aid, combined with a rebound in tax revenue, has boosted confidence across the municipal market and helped some lower-rated credits reach lofty valuations.

Some investors say parts of the market -- from states and cities with chronic fiscal strains to small private colleges grappling with affordability and demographic pressures -- still face abundant challenges. The risk, the money managers say, is that fiscal headwinds such as underfunded pensions and budget deficits will resurface and weigh on portfolios after the aid is spent.

The federal funds “stabilized every balance sheet of every municipality everywhere, but eventually the money will bleed out,” said Nicholos Venditti, a senior portfolio manager at Wells Fargo Asset Management Corp. “I’m largely bullish on munis, but I don’t think investors should ignore that some of this sunshine is artificial.”

Wall Street strategists are already talking about the rally in munis running out of gas. The bonds have offered an oasis in 2021, at a time when most parts of fixed income have delivered losses. The outperformance is due in part to a push by the Biden administration to hike taxes on the wealthy, bolstering demand for tax-exempt funds that have been luring heaps of cash.

The dilemma for asset managers is that they have to put the money to work in the face of ever-rising prices on even the riskiest debt. There’s been a big reward to trading down in credit quality. Junk and non-rated munis have earned 7.1% this year, compared with 1.7% for the broad muni market, Bloomberg Barclays index data show. Treasuries have lost 2.3%.