Decline in Bond Market Has States Nervous

The last three months have not been pretty in the municipal bond market. Spooked by predictions of government bankruptcies and defaults, investors — especially those in big mutual funds — have fled the field, selling off $20 billion worth of state and local bonds in the process. The exodus, in turn, has left states that need to borrow wary. The number of new offerings from state and local governments is down to a level not seen in 11 years .

Basically, as panicked investors sell off their old bonds on the street, states have not restocked the shelves in the market by issuing new ones.

All this turmoil could cost taxpayers money. Interest rates on the highest-rated municipal bonds are up by more than one-third since late August, notes Kinney Poynter, the director of the National Association of State Auditors, Comptrollers and Treasurers . As rates go up, “states have to pay more to issue their debt,” Poynter says, “which means citizens have to pay more for infrastructure projects like roads, schools, etc. So it’s had a dramatic effect.”

This week, Illinois, which has one of the lowest bond ratings in the nation, plans to offer $3.7 billion in bonds to cover its pension payment, one of the biggest tests of investor appetite in the new year. Governor Pat Quinn pushed for the bonds to help the state save money on its pension costs this year.

The outflow from the municipal market could push up interest rates on those Illinois bonds, because there is so much uncertainty toward municipal bonds in general, says Matt Butterfield of the Illinois treasurer’s office. “I think we’ll still get takers on the bonds,” he says, “but we may have to pay a slight bit more.”

That said, the Illinois offering is unusual. Unlike most municipal bonds, the ones in Illinois will be taxable, because the law specifies that pension obligation bonds are taxable. That means, in order to offset the missing tax advantage, the state will have to pay higher interest rates, on top of any premium for investor wariness.

Debt gets political

Most of the new governors, legislators and other state officials swept into office last November campaigned on themes of fiscal prudence. To many, that means reducing their reliance on debt. Maine Governor Paul LePage, for example, told lawmakers his administration would swear off more borrowing, even for buying land or improving buildings. “If the question is cash or credit, the answer is always the same,” the Republican said in his state of the state speech .

But Virginia’s Robert McDonnell, another Republican governor, argues that his state should take advantage of bond bargains on Wall Street. Even though interest rates have risen, they are coming up from historic lows. In other words, they are likely to be lower now than they will be a year from now. Betting that this is actually a good time to issue new debt, Virginia lawmakers are putting the finishing touches on a major transportation bond package before they adjourn this month, in response to McDonnell’s call for “an immediate infusion of funds the likes of which our commonwealth hasn’t seen in decades.”

He said Virginia could create thousands of jobs with a $4 billion effort to improve roads, bridges and railways. “Let me be emphatic about the fiscal prudence of accelerating these bonds now,” he told lawmakers . “Interest rates are at near all-time lows, and bids on construction are coming in at the lowest in the modern era.” 

Churning the waters

California, which has the lowest bond ratings in the country, has no plans to issue bonds until late in the year, in order to save the state hundreds of millions of dollars in interest payments. But its officials are keeping a watchful eye on the market.

Tom Dresslar, a spokesman for California Treasurer Bill Lockyer, says the mass exit from the municipal market is a symptom of irrational fears about the safety of municipal bonds. “Those fears,” he says, “have been generated by a lot of scare tactics and doomsday default scenarios being tossed around by folks like Meredith Whitney.”

Whitney is the best-known prophet of doom for municipal bonds. The banking analyst became famous for correctly predicting financial troubles at Citibank, prior to the collapse of the financial sector. In recent months, she has tried to convince investors that the municipal bond market will be the next to tank.

“It has tentacles as wide as anything I’ve seen,” she told CBS’ 60 Minutes . “I think next to housing this is the single most important issue in the United States, and certainly the largest threat to the U.S. economy.”

In the same TV interview, Whitney predicted at least 50 to 100 municipal defaults. “This will amount to hundreds of billions of dollars’ worth of defaults,” she said. By comparison, when Moody’s Investors Service counted municipal defaults in the four decades between 1970 and 2009, its analysts found a total of only 54.

Much of the uncertainty about the safety of municipal bonds has to do with elevated concerns about the unfunded liability of state pension programs. But Poynter, who represents the auditors, comptrollers and treasurers, downplays this issue. “For us,” Poynter says, “comptrollers have been preparing the annual statements for years revealing that public pensions are underfunded. That’s nothing new to us. That’s been news for years.”

Still, the predictions have reverberated on both Wall Street and Capitol Hill. As mutual funds have been dumping municipal bonds, Congress has been holding hearings on whether states should be allowed to file for bankruptcy, especially in the event they could not pay their pension and retiree health benefits. Federal law currently prevents that, although it allows local governments to file for bankruptcy.

State officials have universally protested this idea, arguing not only that they do not need bankruptcy protection, but that the mere suggestion of allowing bankruptcy is already hurting states and their taxpayers. “The reported bankruptcy proposals suggest that a bankruptcy court is better able to overcome political differences, restore fiscal stability and manage the finances of a state,” governors and legislators of both parties wrote in a letter to congressional leaders. “These assertions are false and serve only to threaten the fabric of state and local finance.”

Contributing factors

The fear of defaults is only one of the forces driving investors away from buying state and local debt. Other factors include tax changes, anticipation of higher inflation, and the end of the Build America Bonds program on December 31, 2010.

Two years ago, Congress created Build America Bonds as part of the federal stimulus package. The bonds were taxable — unlike most municipal bonds — but they came with a higher interest rate, because the federal government paid for 35 percent of the interest costs. States took advantage of the new breed of bond, which appealed to nonprofit organizations and foreign entities that do not need the tax advantages that come with normal municipal bonds.

All told, more than $178 billion of the bonds were sold, according to Bloomberg . The states and local governments in four states — California, Illinois, New York and Texas — accounted for nearly half of the bond sales. But as states and localities rushed to sell them before the December 2010 deadline, there was a glut in the bond market, depressing demand for traditional types of municipal bonds.

The extension of the Bush-era tax cuts last year may also have played a role in the declining popularity of municipal debt. With less income subject to taxation, the tax-free aspect of government bonds holds less allure.

The threat of inflation, always the enemy of low bond yields, adds to investor skittishness. Although Federal Reserve Chairman Ben Bernanke earlier this month told Congress the risk of inflation in the United States is low, some lawmakers and Wall Street analysts argue that the Fed’s efforts to spur the U.S. economy will push prices higher. Inflation risk is especially a concern for states issuing long-term debt. Investors do not want to be locked into low returns for the span of a 30-year bond.

See related stories:
Future of popular Build America Bonds in doubt (12/3/2010)
Tracking the recession: Investors buying up new state-issued bonds (6/9/2009)