By Sebastian Pellejero 

The coronavirus has dealt a harsh blow to state and local government finances. But the municipal bond market rolls on.

Yields there have hit their lowest level since 1982, reflecting a significant increase in bond prices, despite the largest run of municipal-bond defaults in nearly a decade.

The rally has been driven by dynamics new and old, ranging from the extraordinary efforts of the Federal Reserve to backstop the U.S. economy to the continued aversion of many voters to new municipal issuance. That resistance might result in borrowers missing out on one of the great issuance opportunities on record, at a time when many are being crushed by the falloff in taxes, fees and other revenues.

"Borrowers are going to scrutinize issuing debt for new projects going forward," said Howard Cure, director of municipal bond research at Evercore Wealth Management. "States have delayed a lot of tough decisions in anticipation of federal money and will have to start making cuts if that money isn't forthcoming."

Even with coronavirus losses weighing heavily on state and city coffers, investors are piling back into municipal debt, hungry for yield and seeking more safety than the stock market can provide. Investors have put about $28 billion back into muni mutual funds since the end of April, according to Refinitiv Lipper, nearly 60% of the amount pulled during the height of the pandemic.

Inflows have continued even as defaults rise. Universities, convention centers, student housing and senior living facilities are confronting significant disruptions to revenue, sending some into insolvency. As of July 31, there were a total of 50 municipal defaults, according to Municipal Market Analytics -- the most since 2011.

Public officials meanwhile have been hesitant toward taking on debt during economic uncertainty. New muni issuance is down nearly 2% this year, according to Refinitiv, even when including taxable bonds. Many borrowers are responding to the coronavirus hit by either cutting spending or coming to market to refinance existing debt at near-zero interest rates for savings.

"You're seeing some caution around the amount of borrowing," said Tom Doe, president of Municipal Market Analytics. "There's increasing concern that more credit problems will emerge."

In Wisconsin, the state government is cutting spending by $250 million across all agencies and recently completed a series of taxable bond deals that helped cut debt service costs by $29 million. The 2017 tax overhaul limited borrowers' ability to refinance old bonds by selling tax-free debt, through what are called advance refundings.

While recent federal aid has helped the Badger State manage expenditures, the problem now is making up the revenue lost during the coronavirus shutdown, said David Erdman, capital finance director.

"This is not going away anytime soon," he said. "We have started making cuts, but at this point we're not going to be forced into the capital markets for cash flow purposes."

Many borrowers are waiting to see what money they will receive from Congress in the next relief bill. Congress hasn't approved any aid to make up for lost revenue, and cities and states are suffering huge losses in sales and income tax collection as the pandemic has driven unemployment to record levels and eroded consumer spending.

Even with federal aid, some issuers might still sell new bonds, said Greg Saulnier, managing analyst at Refinitiv MMD.

"You have to believe some state and local governments are waiting on the sidelines," he said. "At record low yields, most of them certainly can hit the market."

Write to Sebastian Pellejero at sebastian.pellejero@wsj.com

(END) Dow Jones Newswires

August 14, 2020 08:36 ET (12:36 GMT)

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