Bonds take a blow
As the director of debt financing for Seattle, Michael Van Dyke thinks that the city did well with the sale in early March of $25 million of 20-year general obligation bonds. At the conclusion of a vigorous bidding process,
he had the luxury of weighing offers from 14 separate syndicates before settling on a bid at 3.7 percent interest. “There was strong demand for the bonds,” he says. “We were very pleased with the results.”
A sale of California redevelopment district bonds was not as well received recently, says Michael Pietronico, chief executive officer of New York-based Miller Tabak Asset Management, an investment firm active in the municipal market for private investors. “The 9 percent interest rate was quite punitive,” he says.
For government financial officers relying on the municipal bond market, 2011 is the best of times and the worst of times. It all depends on a government’s credit rating.
In the case of Seattle, the city’s Triple-A credit rating attracts buyers who are competing for the relative sparse supply of quality offerings. However, because of California’s budget problems, a rush by redevelopment agencies to sell the bonds — which may be dropped by the state government in the future for budgetary reasons, along with a threshold investment grade Triple-B rating — make for a tough sell.
The contrasting fate of those two West Coast issues is not isolated, as reflected by the sharp reduction in volume of issues in the huge municipal bond market. February saw the slowest one-month rate of bonds to market since 2000: just $28 billion. With lethargic sales reports continuing into March, the first quarter of 2011 may result in the issuing of the lightest volume of municipal bonds in more than a decade.
Boom and bust?
While 2010 saw a record $430 billion in municipal bonds, 2011 may see a total of $200 billion if it continues throughout the year at the pace seen in the first quarter. Activity had become so anemic in late March that a recent headline in the Wall Street Journal declared, “A Deep Freeze Hits Muni Market.” It is enough to give government leaders the shivers. “It’s definitely turbulent,” says Harvey Kennedy, chief administrative officer of Shelby County, Tenn. “We are proceeding very carefully. Timing seems to be the secret.”
Shelby County recently refunded $79.7 million of its 2003 Series A bonds, saving more than $9 million — including almost $6 million in an upfront premium, with additional interest savings over the remaining life of the bonds. “We pay careful attention to finding the market at the right time,” Kennedy says.
The municipal market is critical to the financial operations and capital programs of state and local governments, with a total market of 1.5 million municipal bonds outstanding, totaling $2.9 trillion in outstanding debt. Unlike the corporate bond market, the municipal bonds are 70 percent owned by individual investors and mutual funds that cater to investors who want income free of federal taxes and often state and local taxes. (A program that was part of the American Recovery and Reinvestment Act of 2009 — Build America Bonds — was designed to attract investors from institutions that frequent the corporate and U.S. Treasury markets, but it ended in December 2010.)
Certainly, the financial stress among a few high-profile governments facing long-term liabilities for retirees and immediate budget deficits helped create some of the anxiety related to municipal bonds. However, most often blamed is the prediction by bond analyst Meredith Whitney in an interview on CBS News’ “60 Minutes” last December where she said, “You could see 50 sizable defaults. Fifty to 100 sizable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults.”
Historical view
Whitney’s remarks are all the more remarkable because they were so disassociated with the history of the municipal bond market. According to Fitch Investors Service, the historical default rate in the municipal sector is less than one-third of 1 percent, compared to a corporate default rate that exceeds 10 percent.
A separate analysis of the municipal market by Bernstein Global Wealth Management, showed that even during the Great Depression of the 1930s, municipalities kept their promises. In 1935, the worst year for defaults during that period, only 1.8 percent of municipal securities went into default. By 1937, practically all of the defaults by larger issuers were paid back, and the average default recovery rate was 97 percent. In fact, except for Arkansas in 1933, no state has defaulted on its debt in the past century and even then, Arkansas bondholders were paid in full. That tracks with an overall recovery rate for general obligation and tax-backed debt at 100 percent, according to a fact sheet issued in February by the National Association of State Auditors, Comptrollers and Treasurers and 10 other state and local government associations.
Even today’s highest-profile communities in financial distress — including Harrisburg, Pa.; Vallejo, Calif.; and Jefferson County, Ala. — amount to only 0.3 percent of the municipal debt outstanding. Even more telling about the relationship of the current financial woes and the municipal bond market volatility is the fact that all of these prominent examples traced their difficulties to events that preceded the start of the recession.
Late in 2010, state governments became the targets of conservative political leaders who pointed to underfunded pension plans as another example of overcompensated government workers. Some even offered proposals to ban states from entering bankruptcy court, even though no state has ever filed for bankruptcy and none were even contemplating or asking for such a dramatic action. Government leaders countered that even talking about allowing a state bankruptcy to take place would damage government finances.
“Allowing states to declare bankruptcy is something our members have neither requested, nor would ever consider, to deal with holes in their budgets,” Chris Whatley, director of the Council of State Governments‘ Washington office, said in a statement. “The mere existence of a law like this could have some very detrimental effects for the states, such as raising interest rates and making the market even more volatile. That would only serve to hurt our members as they look to bonds to finance long-term projects.”
Added to the dire predictions were the noisy confrontations in state capitals as governors, with proposals of varying degrees of severity, tried to wring concessions from municipal workers. When state and local workers balked, sometimes through angry demonstrations, the news further unsettled the markets.
Bond market reacts
With such turmoil, jittery investors of municipal bond mutual funds withdrew about $26 billion of their assets from mid-November until early March, which created enormous disarray as the funds redeemed bonds to meet redemptions. One exchange-traded fund that tracks the municipal bond market fell more than 10 percent from its peak in August 2010 to the trough in January, though the market recovered about half of that amount in the next month or so. Interest rates, which move inversely to bond prices, were up substantially in March from August 2010.
Much of the trauma in the municipal bond market can be attributed to loose talk about government finances, says Jeffrey Esser, the executive director of the Chicago-based Government Finance Officers Association (GFOA). “It’s disruptive for people to be claiming that the sky is about to fall down,” he says. “It affects all city and county governments, small and large.”
Esser acknowledges that many governments are facing difficult budget years, not surprising after the worst recession since the Great Depression. “Yes, it’s tough out there,” he says. “But there have been virtually no defaults on municipal bonds, no bankruptcies by state and local governments. The scare mongers have spooked the retail investors.”
Much of the concern about municipal debt and liabilities is misplaced. Esser says that, on average, debt consumes only 4 to 5 percent of a government’s operating budget, and the average pension plan payment comprises only 3.8 percent of spending. “In Wisconsin, which has one of the best pension plans in the country, the newly elected Gov. [Scott Walker] makes out that it’s about to collapse,” he says.
Even after the two worst years of the recession, he notes, the largest 100 pension plans are still on average 80 percent funded, meaning they have sufficient assets today to pay 80 percent of their future obligations, a generally accepted standard for sufficient funding. “There’s no question that a few places like New Jersey and Illinois have a problem with the pension plan,” he says, “But, because there’s a burglary in some large city does not mean that every house is going to get broken into.”
Esser says that GFOA is making a concerted effort through its own publications and state and local groups to change what he believes is a false impression about the status of public sector finances. “We are getting the truth out,” he says. “Once the fear factor goes away, we’ll be all right. Ironically, during the worst part of the recession, the individual investor fled stocks first to U.S. Treasury securities and [then to] municipal bonds. Once everything calms down, demand for bonds will return.”
Supply and demand
Pietronico has a considerably different take on what is happening in the municipal bond market. For government issuers with good credit ratings, he says the “markets are open, and borrowing rates are attractive.” But, he notes, that “the window is very small and very selective. It’s not open to everyone at the moment.”
Rather than attributing the market volatility to politicians and analysts, Pietronico believes that the number of bond issues outnumber the limited pool of buyers. “There’s too much supply in the near term,” he says.
Behind the lack of demand, he says, is an economy that is just now emerging from a very difficult recession, with lingering high unemployment. “It’s too soon after the financial crisis to turn on a dime,” he says. “If the unemployment rate turns to normal levels, it will be a better backdrop to borrow for issues that are economically sensitive.”
Pietronico attributes the large withdrawals from municipal bond funds to investor concerns about a potential increase in the rate of inflation. Rising prices, he says, would prompt the U.S. Federal Reserve Bank, which sets short-term interest rates, to raise rates and slow the economy.
“It was solely caused by inflation fears,” he says. “With the economy and inflation picking up, there’s the possibility of negative performance if the Federal Reserve raises rates.”
Despite the difficult terrain of the government security market, communities are still issuing bonds and hoping for the best. Dallas Center, Iowa, with a population of 1,800 residents, issued a $1.455 million 20-year bond with an interest rate of 3.654 percent that will be used for street improvements, says Cindy Riesselman, city clerk. “We were just trying to meet our budget deadline,” she explains. “We were hoping that the rates would stay low. We were pleasantly surprised.”
However, Salt Lake City was able to lock in a rate of 3.192 percent for its 20-year $25 million bond issue in a private placement with a bank, which had the added benefit of fewer documents and legal fees. “We were told that if we had waited a day or two more it would have been 20 basis points higher,” says Dan Mulé, city treasurer. (The extra basis points would have raised the rate to 3.392 percent.) “It’s a volatile time. Fortunately we went in and locked a rate on a good day. It doesn’t always work out that way.”
Mulé says that the city’s pristine Triple-A credit rating helped Salt Lake City land the best rates, which keep its expenses to a minimum. “Our advisers say that our name is valued when we come to the market,” he says, noting that the lack of supply of bonds works to his city’s favor. “It’s a good time to borrow.”
Still, the volatility is enough to give pause to even the best of issuers. “The market is precarious,” he says.
Robert Barkin is a Bethesda, Md.-based freelance writer.
Related Stories
- Podcast: Expert says municipal bond market is stable
- NLC official refutes ’60 Minutes’ report on municipal insolvency
- Sea change: Municipal bonds are being rocked by the waves of problems affecting a global credit market
- Financial lockdown: Lack of bond insurance stalls government projects
- Releasing the bonds: New federal instruments fund state, local infrastructure projects