PANDEMIC CREATES NEW STRESSES FOR TAX-FREE AND MUNI FUNDS
The pandemic-fueled volatility of 2020 had the effect of driving total, taxable, government, and retail U.S. money-market fund assets higher, but it had the opposite effect on the already-struggling tax-free and municipal-fund sector of the industry, reducing the number of tax-free funds by nearly 15 percent since January 2020 and assets in those funds over the same period by 41.7 percent to the lowest levels since iMoneyNet began tracking tax-free fund data in 1981.
As of end-May 2021, total assets in tax-free funds stood at $92.4 billion, down from $107 billion in early January and from $141.0 billion in January 2020, just prior to the outbreak of the COVID pandemic, as the table above shows. Similarly, the number of funds fell to 162 on May 31 of this year, a reduction from 185 as the year began and from 187 in early 2020.
Declines Began With Financial Crisis
Clearly, the effects of the pandemic – dramatic as they have been for tax-free money funds – are more evolutionary than revolutionary and have simply accelerated a process that began with the financial crisis, when rates fell, as they did last year, to near zero.
“The truth is that municipal funds are difficult to manage, issuers are inconsistently scattered nationwide, and funds favor large states with lots of municipal jurisdictions rather than small states with fewer cities and towns,” a Barron’s report observed recently.
As the table indicates, tax-free money funds weren’t always the stepsisters of their taxable counterparts. As recently as 2014 when the dust was still settling from the 2008 financial crisis and as regulators were considering sweeping reforms on money-market funds, some 420 tax-free funds held assets of $275.0 billion. Reforms imposed on money funds in that year, which were fully implemented in the fall of 2016, had by January 2017 reduced total assets by nearly 72 percent and the number of funds by nearly 56 percent.
Prior to 2014, tax-free funds were an even more significant component of the money-fund industry. Assets in such funds reached their highwater mark in August of 2008 at $528.4 billion – 15 percent of total assets – and didn’t fall consistently below $400 billion until January of 2010 or below $300 billion until August of 2011. As of May 31 of this year, tax-free assets comprised 2 percent of total money-fund assets.
Tax Reform, Low Rates, Alternative Funding Sources
Institutional muni investments waned after the 2017 tax-law overhaul, although interest in generating tax-free income rose among retail investors after deductions on state and local taxes were capped in separate legislation, the WSJ noted.
Money managers currently are struggling to find enough muni securities to invest in, and with interest rates near zero, local and state governments are finding borrowing sources other than typical short-term floating-rate bonds that characterize the municipal market. “The pandemic accelerated a decline in yields after the Fed’s pledge to keep rates near zero,” the Journal reported. “The drop in yields is squeezing money-fund manager profits, shrinking investor returns, and dissuading debt-issuing governments from short-term securities.”
Fund managers are also reacting: Vanguard, Federated Hermes, and Dreyfus have closed state-specific tax-free money funds, citing the high cost of operating tax-free funds, shortages in the supply of municipal credits, and the current ultra-low rates.
“Deteriorating government finances – despite COVID-related government support – could further shrink debt supplies that meet money-funds’ high thresholds for creditworthiness if cash-strapped governments get downgraded or issue less debt,” the Journal reported.
Broad-based infrastructure investments are likely to benefit many states and municipalities, and therefore boost municipal spending, but agreement in Congress on such investments is far from certain.
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