Debt ceiling standoff may dampen muni supply

A prolonged showdown over the U.S. debt limit may depress muni bond supply the first half of the year as issuers pull back amid political volatility and potential spending cuts.

With supply already weak just a month into the year — and following last year's lackluster levels — a battle over the debt limit may worsen the situation, said Vikram Rai, Citi's head of municipal strategy.

"The worry is the debt ceiling crisis will further reduce issuance as issuers sit out market volatility," Rai said. That will "further frustrate investors who are waiting to put their cash to work."

The debate over lifting the U.S. debt limit, last raised in December 2021, is expected to be particularly acrimonious this year. House Republicans are determined to link any increase with budget cuts or other fiscal reforms, and a failure by House Speaker Kevin McCarthy to win concessions from Democrats could endanger his seat. The two sides have until June at the earliest before the U.S. hits its $31.4 trillion limit.

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The political uncertainty could eat into the number of what Rai calls "clean weeks" for issuance.

Issuance is already light during the 13 holiday weeks of the year, Rai said. Supply is also lower during weeks the Federal Open Market Committee meets, such as this week, where issuance is a paltry $847 million.

Adding the eight FOMC weeks to the 13 holiday weeks "leaves only 31 clean weeks for issuance," Rai said.

If, during those 31 weeks, "supposing there's volatility around the debt ceiling crisis, issuers will want to pull back," he said. That could mean pushing issuance forward into a calendar that's traditionally already back-loaded in the end of the year.

"No one wants to come to market in a $14 billion week," he said.

Citi had predicted gross municipal supply for 2023 to land around $450 billion, but now is "already concerned about the year supply forecast," Rai said.

Barclays does not expect a U.S. default, but notes that a similar standoff in 2011 sparked a rally in Treasuries that saw its yields drop nearly 100 basis points. Munis, meanwhile, lagged the rally, said Mikhail Foux, Barclays head of municipal strategy and research.

"The biggest factor is market volatility and for the Muni/Treasury ratio, that's where you going to see the biggest effect," Foux said. "We expect some kind of risk-off rally."

Foux said he expects issuance to remain relatively unaffected by the debt limit debate, unless market volatility becomes pronounced, or if the Treasury Department moves to suspend sales of State and Local Government series securities, which would mean less refundings.

"You're going to see some market volatility but not a lot less issuance, unless we have a situation where the market is really volatile, because clearly no one wants to issue at that time," he said.

Foux said he's fairly optimistic that the standoff is resolved before the so-called X Date, which Barclays estimates will hit in August.

"Neither side wants a repeat of 2011," when S&P Global Ratings downgraded the U.S., Foux said.

"There's a pretty decent chance we resolve it before that, but if not that will create all kinds of issues for various sectors."

Meanwhile, Biden administration officials are warning that budget cuts or a return to fiscal 2022 discretionary spending levels, as House Republicans have proposed, would hurt state and local spending on infrastructure projects and the execution of the $1.2 trillion Infrastructure Investment and Jobs Act.

"We'd build less," said White House infrastructure coordinator Mitch Landrieu during a press gaggle Tuesday in response to a question about the impact of spending cuts or budget gaps on infrastructure spending.

"If you have less money, you build less," he said.