New Municipal Issuance: Supply Constraints to Persist?

Roadblocks to Refunding Continue to Pressure Tax-Exempt Supply

The flow of newly issued bonds is the lifeblood of any bond market. For municipals, in particular, refunding deals have played a key role in new issuance. The reliance on refunding debt is so high that in a typical year, it makes up one-third to 40% of supply. As opposed to new money bonds, which are issued for new projects, refunding bonds replace outstanding debt (aka refinancing). Several recent policy decisions have curtailed the use of refunding issuance, severely reducing tax-exempt supply in the market.

Pre-Refunding Bonds Become Taxable

In 2018, the Tax Cuts and Jobs Act eliminated tax-exempt pre-refunded debt – a subset of refunding bonds. As a result, refunding debt dropped to 18% that year, slowly creeping up to 31% in 2020. Low interest rates ensured that refunding outstanding debt still made sense, and even pre-refunding taxable debt could be advantageous.

A Decade of Municipal Issuance: New Money vs Refunding

Source: The Bond Buyer. ^*As of 10/31/2022.

Although refunding debt does not seem likely to reach 40% of new issuance as long as this policy is in place, there does seem to be a new equilibrium. Further, the need for taxable refunding debt fed a growing acceptance of taxable municipal debt in general. The result was taxable new issuance moving from the historically high single-digits to 30% in 2020. Digging into the numbers shows that recent increases in annual municipal issuance are solely due to this taxable issuance. Tax-exempt issuance has been flat.

A Decade of Municipal Issuance: Taxable vs Tax Exempt

Source: The Bond Buyer. ^*As of 10/31/2022.

Impact of Rising Interest Rates on New Municipal Issuance

In a rising rate environment, occasions for cost savings through refunding debt decline. And finding opportunities to pre-refund taxable debt for tax-exempt debt are even more remote. In an effort to reduce annual borrowing costs, refunding bonds are likely to push out maturities – a position that weakens the long-term borrowing options for an entity.

Higher interest rates will hit all new issuance, of course. Municipal project planning often takes years, and rising rates will increase project costs well above previously approved levels. Projects funded by new money debt can be delayed or reduced in size to make up for increased borrowing costs.

Refunding Debt Sets the Tone for the Market

Fewer opportunities for tax-exempt refunding debt suppress new money issuance as well. Refunding bonds reduce annual payments for existing debt, which increases the affordability of new debt. After several years of flat tax-exempt new issuance, 2023 seems unlikely to be the year this trend turns around, as the economic feasibility of refunding will be further out of reach.

Back to Basics: Demand Expected to Outpace Supply

Our outlook on supply combined with higher rates means, once again, income investing matters. Yields are now back at much more meaningful levels after being muted by a strong economy and robust demand over the past 3-4 years. As we finish up the year and into 2023, demand for tax-exempt income will likely outpace supply of new issues, setting the market up for solid performance.

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