Muni Market Under Siege

12/29/2010 2:07 pm EST


Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, writes that disenchanted muni investors are increasingly voting with their feet as governments grapple with deficits and white elephants.

All states but Vermont are legally required to balance their budgets one way or another, but most honor those commitments in the breach with ample amounts of creative accounting. The issuance of tax anticipation notes is common, as is the reclassification of normal budget expenditures as capital outlays that can be financed by borrowing.

Still, many municipal bond investors are beginning to discipline state and local governments, which will curb their spending.

A Market Past Its Prime
In 2006, bond issuers insured about half of new municipal bond issues, which gave them triple-A ratings. That number plummeted to 7% this year, however, as bond insurers, decimated by the subprime mortgage collapse, withdrew.

Furthermore, the demise of major muni bond dealers Bear Stearns and Lehman Brothers has reduced trading activity and increased already-wide spreads between bid and ask prices.

Historically, general obligation (GO) bonds, backed by the full taxing authority of the municipality, were considered higher quality than revenue bonds backed by toll collections on bridges or water system revenues. However, the growing plight of state and local governments and the resulting threats of rating downgrades, much less defaults, have made many revenue bonds rivals with GOs. Indeed, in early 2009, an average double-A rated GO yielded 0.40 percentage points less than a double-A revenue bond, but the gap has shrunk to a mere 0.03.

Furthermore, the GOs of municipalities such as Jefferson County (Birmingham), Ala., Harrisburg, Pa., Menasha, Wisc., and Buena Vista, Va. are under fire because of their obligations to support failed sewer systems, incinerators, steam plants, and municipal golf courses, respectively. In some cases, such as Harrisburg, bankruptcy is a distinct possibility.

Build America on Life Support
Another threat to municipal bond financing and therefore state and local government spending is the scheduled expiration at the end of this year of the federally-sponsored Build America Bonds program. Over $150 billion of BABs have been issued from their inception in April 2009 through October 2010. They subsidize 35% of the interest rate paid to investors on their taxable munis.

BABs accounted for about 30% of munis issued so far this year and allowed state and local governments to attract buyers such as foreign investors and pension funds that usually don’t buy tax-exempt obligations. [The program’s fate was up in the air early Thursday as Senate Democrats pushed for an extension as part of the proposed compromise on the Bush tax cuts—Editor.]

In any event, municipal bond yields have jumped lately, not only in absolute terms but in relation to Treasury yields with which they’re usually compared. In addition to heavy issuance lately and worries over rating downgrades and defaults, the growing likelihood that the Bush-era tax rates for high income taxpayers will be extended has reduced the appeal of federal tax-free investments.

Investors Head for Exits
These growing uncertainties over state and local government economic and financial health, coupled with a surge in new issues in past months and the resulting slump in prices, precipitated the recent investor retreat from the muni market. Record outflows from municipal security mutual funds in late November followed 19 consecutive weeks of inflows.

The net effect of all these new forces is that state and local governments are no longer a source of high-paid, steady jobs and income and consistent outlays. Employment is falling and many employees are suffering from involuntary furloughs and increased responsibility for their health and pension costs. New employees often are paid much less than comparable incumbent workers and enrolled in much cheaper defined contribution as opposed to defined benefit pension plans. In nearly unique fashion, state and local spending has fallen substantially in many recent quarters.

[Doug Fabian recently listed no fewer than seven deadly risks to municipal bonds. Earlier this year, Richard Band recommended a muni fund offering diversification and some protection against a spike in long-term rates. Marilyn Cohen warned months ago that local budgets were headed for radical surgery—Editor.]

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