Municipal-bond investors are turning to one of the market’s steadiest corners as angst grows that a US recession is ahead: obligations sold for utilities like water, sewer and power.

The bet is that bonds backing such essential services will prove resilient should the economy struggle, an increasingly relevant debate as the Federal Reserve ramps up borrowing costs to combat inflation. No matter how tight household budgets may get, fund managers say, people rarely cut back on utility payments.

It’s a wager with a solid track record. These sectors have fared better than the overall muni market through at least three stretches of severe economic stress — this year, as consumers grappled with soaring prices; in the worst months of the pandemic-fueled market turmoil in 2020; and in the 2007-2009 recession.

“People always have to flush the toilet and brush their teeth,” said Nicholas Foley, senior portfolio manager at Segall Bryant & Hamill.

Investors have already been favoring munis, and in particular those linked to utilities, amid the bond-market carnage of 2022. Electric-system-backed munis have lost 5.6% this year, while water and sewer bonds have tumbled 6.1%, although both are doing better than the broader muni world, which has declined 6.4%, Bloomberg index data show. The overall US bond market is down 8.3%.

Barclays pointed out the utility sectors’ appeal in a report last week.

The bank is positive on tax-exempt debt for the second half of this year, “but given the looming economic slowdown, we like trading up in quality and sticking to more defensive sectors,” according to a note written by analysts including Clare Pickering. “One such sector is municipal power, water and sewer, which should provide good protection for bondholders.”

Essential-service muni deals drew solid demand last month. The Metropolitan Water District of Southern California sold about $253 million of debt in July with a top grade from S&P Global Ratings. A 10-year segment priced to yield 4 basis points below benchmark munis, data compiled by Bloomberg show.

The issue drew orders from 58 different investors, more than double the amount of a sale a year earlier, according to Katano Kasaine, the agency’s chief financial officer.

Dora Lee, director of research at Belle Haven Investments, said the firm has added utility bonds in anticipation of a potential recession, after observing early in the pandemic and in 2008 how people tended to scrimp on other spending to be able to pay essential bills.

“You have to look at the value in relation to how it performs against other sectors,” she said. “With everyone preparing for a recession, we’ve seen that you might not get as high of a yield in, say, a high-yield bond, but the trade-off between the yield and credit safety in a utility bond is the calculus that we’re constantly doing right now.”

GW&K Investment Management has also found that essential-service munis tend to outperform during recessionary periods. Sheila May, the firm’s director of municipal-bond research, stresses the relative affordability of utility payments, whether for retail, commercial or industrial uses. She pointed to S&P Global Ratings data showing combined water and sewer bills comprising less than 2% of median household income.

“People forget how much we spend on things we consider as essential as water, sewer and power,” compared to pricier items now seen as necessities like cellphones and streaming services, May said. Utilities are “one of the sectors that holds up quite well under a variety of circumstances, but certainly in a recessionary environment.”

—with assistance from Amanda Albright

Puerto Rico’s former governor and secretary of justice, Wanda Vazquez, was arrested Thursday on allegations she allowed an international bank operating on the island to hand-pick a financial regulator in exchange for $300,000 to finance her failed 2020 election campaign. Vazquez, 62, who was governor from 2019-2020, faces seven counts of corruption, US Attorney for the District of Puerto Rico Stephen Muldrow said.

Municipal-bond dealers are failing to provide their customers with the best execution and fair pricing, taking advantage of the prevalence of mom-and-pop buyers in the market, in violation of regulators’ rules, according to a new academic study.

Bond markups to retail customers “have remained high and variable throughout the past 15 years despite significant regulatory efforts to enhance transparency and improve execution quality,” John Griffin and Samuel Kruger of the McCombs School of Business at the University of Texas at Austin, along with Nicholas Hirschey of Portugal’s Nova School of Business & Economics, wrote in the paper, to be published in the Journal of Finance.

The Municipal Securities Rulemaking Board began its transaction-reporting program in 1995, with real-time trade reporting established in 2005. From the beginning, analysts have flagged the wide disparity in prices, especially in the period immediately after new issues were sold and those on trades below $100,000 — which tend to be retail customers, rather than professional money managers.  

MSRB rules require dealers to obtain the most favorable pricing for customers given current market conditions, what’s known as “best execution,” and also obligate them to ensure that prices are fair and reasonable, according to the authors.

“Guidance for both rules emphasizes that trades on the same day should generally have the same price,” the study said. A more recent rule change requires dealers to disclose markups and mark-downs on certain transactions.

This should, at least theoretically, deliver uniform and consistent pricing, and yet the authors found that instead prices are highly variable, the study states. They conclude that some “dealers appear to use their pricing discretion to charge higher markups to small customers when investors are less likely to notice.”

“Enforcement” in the municipal market for these violations, “appears to be very limited,” the authors write.

From August 2016 to August 2021, the Financial Industry Regulatory Authority took only 12 disciplinary actions involving 204 transactions related to fair pricing of municipal bonds, a “small” amount relative to the total number of trades, indicating that “enforcement appears spotty,” the researchers concluded.

The paper, an advance copy of which Bloomberg received from a McCombs School of Business media representative, used MSRB trade data from July 2011 through December 2017 and an expanded Wharton Research Data Services dataset from January 2005 to December 2019. For both datasets, the dealers weren’t identified.

“Markup differences represent different prices for the same security from the same dealer at essentially the same time, which would seem to be a clear failure of pricing fairness according to MSRB regulations and guidance,” the study said.