As COVID-19 continues to spread rapidly across the globe, the eventual impact on economic growth is impossible to fully assess. While the efforts associated with containing the coronavirus are the obvious priority, the reaction of the capital markets in response to the pandemic has created a separate set of challenges for municipal entities.

The current uncertainty has resulted in a stark flight-to-quality, with high demand for safe haven assets such as U.S. Treasuries, sending yields to near-historically-low levels and causing credit spreads – the additional yield compensation for credit securities versus comparable-duration Treasuries – to widen sharply. While the market value appreciation associated with falling yields will likely increase portfolio values, municipal entities should closely monitor some potentially adverse consequences.

Liquidity Needs

Market liquidity, particularly as it pertains to non-federal government securities, has been modestly impaired in this time of heightened market stress. Most notable has been the wide bid/ask spreads – the difference between a security’s perceived market value and the price at which it can be sold in the market. While the Federal Reserve Bank (“Fed”) has taken a number of actions seeking to help improve general market liquidity (asset purchases, broadened repurchase agreement facility, commercial paper facility, etc.), these actions have not yet resulted in normalized market liquidity. This is not a hindrance during normal market conditions; however, it does validate the emphasis placed on: (1) considering anticipated cash flow needs in the investment strategy development process; and (2) ensuring that there is a minimum allocation to highly-liquid sectors purposely maintained in investment portfolios to preserve the ability to responsibly raise cash if an unexpected need arises.

Reduced Income Potential

The Fed has cut its benchmark federal funds rate by 150 basis points (1.50%) in recent weeks due to the evolving economic risks of the coronavirus. This action, combined with the aforementioned flight-to-quality, calls into question the amount of income that can be generated in an investment while rates remain at these suppressed levels. Further complicating matters, this reduced income may come at a time when municipalities are reeling from potentially lower tax revenue from decreased economic activity and increased public health expenditures as communities grapple with the effects of combatting the coronavirus. While many states and municipalities across the country are in a better financial position than they ever have been, many are using surplus and rainy day funds to provide timely support to their communities.