The coronavirus triggered a liquidity crisis in municipal bonds, but the volatility that resulted has been brewing for a decade.
Desperate sellers across most markets sold assets at deep discounts last month as the spreading new coronavirus left investors fearful and hungry for cash. Perhaps no investment flipped from coveted haven to spurned hot potato as quickly as municipal bonds.
Prices have started to recover as U.S. lawmakers authorized the Federal Reserve to prop up a wide swath of state and local government debt. But the marketwide breakdown exposed a new vulnerability in the nearly $4 trillion municipal market: a concentration of power and risk resulting from a fundamental shift in how muni bonds are bought and sold on Wall Street and on Main Street.
More money than ever is managed by a few financial behemoths that can swallow large chunks of debt at premium prices and don’t shy away from risk. Meanwhile, the banks and brokers that trade munis have become less inclined to warehouse debt.
That shift left the market susceptible to extreme volatility when worried investors fled bond funds, triggering waves of forced selling with few other buyers willing to pay top dollar. Yields on 10-year bonds doubled in three days, a price drop never seen before, according to Refinitiv, and the S&P Municipal Bond Index gave up more than a year’s worth of gains. State and local governments were locked out of the debt market for days and investors who cashed out likely suffered tens of millions of dollars in losses. Yields rise as bond prices fall.
(Read more: WSJ.com: Markets)