With developed world governments strapped for cash, many hope the sub-sovereign or municipal bond markets can take on more of the local funding load. It may not work out that way. In Europe, sub-sovereign issuance has grown but it remains a fragmented and loan-driven market. In the US, the municipal market is huge but issuers are under increasing strain. Geraldine Lambe reports.
In 2009, bond issuance from all European states and local governments grew to more than €78bn. While this may be a drop in the ocean compared to the huge US market - which sees total annual issuance in excess of $300bn and has outstandings of more than $2800bn - it is almost double the volume of 2008, and almost four times the issuance seen in 2000. But behind this positive growth trend is a complex and less optimistic picture.
For one thing, the European market relies almost entirely on Germany. Of last year's total, €57.6bn was issued by the country's states and cities. And some believe that this figure will shrink, not grow.
"The municipal market barely exists in Europe; it is driven by sub-sovereign issuance - and that is dominated by volumes from German states," says Clemens Popp, global head of financial institutions and public sector origination at UniCredit, which leads the Thomson Reuters' league table for municipal/state/province issuance in euros. "And with the tax receipts looking increasingly favourable in Germany, I expect state funding requirements - and therefore issuance - to decrease in 2011."
More importantly, one of the key characteristics of the European market is the dominance of the loan market because of the availability of cheap bank or government funding. Despite more conservative lending by banks and constrained public balance sheets, Mr Popp believes this is unlikely to change. "Germany has a very competitive loan market for municipal borrowers, led by state development banks and Sparkassen; bond markets cannot compete with them on price," he says.
Market barriers
For sub-sovereign or municipal borrowers in countries with less favourable economic outlooks, the funding need may be growing but fears around sovereign debt levels could prove an impenetrable barrier.
"The theory that many regions and local authorities will need to reduce their dependence on government borrowing by accessing private capital is sound in principle," says Martin Egan, global head of origination at BNP Paribas. "But the big question is whether or not they will be able to escape the constraints imposed by their sovereign's credit rating and debt levels."
This problem is amply demonstrated in Spain, where funding requirements of sub-sovereign issuers have rocketed but the country's credit rating and economic outlook are proving difficult to overcome. Regional issuers are only able to access the capital markets at maturities much shorter than they need, or are having to seek more imaginative solutions, says Mr Popp.
The government of Cataluna, for example, is looking to place €1bn to €2bn of debt via a retail bond sold into the market by Spanish banks. Expected to be priced at Euribor plus more than 300 basis points, investors can hope to get a coupon in excess of 4.5%.
"But this only buys [Cataluna] time," says Mr Popp. "This is little more than a kind of bridge financing to a longer-dated funding exercise in the near future."
Moreover, Mr Popp says that recent distribution patterns for any Spanish paper reveal that demand is overwhelmingly domestic - from houses such as BBVA and Caja Madrid - meaning international appetite has dramatically declined. "Germany used to be a significant buyer of Spanish paper, but widening spreads and the volatility of the paper has led to subdued appetite from traditional buyers such as Germany," he adds.
Europe's barriers
Other barriers to the European sub-sovereign and municipal markets are its heterogeneity and lack of common credit enhancement facilities. The sheer size and homogeneity of the US market facilitates high institutional and retail participation. In the multiple markets of Europe there is no credit enhancement facility, and many municipal issuers do not even benefit from the kind of tax incentives that underpin US volumes.
Spencer Lake, global head of debt capital markets and acquisition finance at HSBC, says this is a big problem. "The fact that US municipal issuers are able to credit-enhance their paper from BB to BBB, for example, has been the basis for the market's willingness and ability to fund the country's local governments. The lack of such a wrapper is another barrier to an already fragmented European market," says Mr Lake.
Introducing common tax incentives would be "extremely challenging", he adds, but credit enhancement is not beyond reach. "Europe needs a similar credit-enhancement mechanism to that in the US," he says. Mr Lake suggests the credit guarantee facility launched in April by the Asian Development Bank (ADB) and Association of South-east Asian Nations (ASEAN), along with China, Japan and South Korea, is a possible model.
While the $700m credit guarantee and investment Facility (CGIF) will target the region's corporate debt - supporting growth by guaranteeing local currency-denominated bonds and making it easier for firms to issue local bonds with longer maturities - Mr Lake believes something similar could be viable for Europe.
"The ADB-backed CGIF shows how it is possible to overcome some of the potential hurdles to developing regional markets," he says. "And there is a growing need in Europe for something similar to support municipal funding."
Loss of appetite
However, Europe's appetite for any kind of concerted action has waned, not grown, since the financial crisis and Greek bailout. This seems to be true even in pursuit of developments that could support infrastructure investment and help spur economic growth - a major driver of the municipal market in the US and seen by many as an obvious answer to Europe's woes.
European Commission president José Manuel Barroso raised the idea of European project bonds during his State of the Union speech in Strasbourg in September, describing how they could be used to finance new European infrastructure projects. But key MEPs from a newly created committee on the future of the multi-annual budget immediately poured cold water on the idea.
"For me, it's a real change to enter into the world of EU [pan-European] debt," said Jutta Haug, Socialist MEP and chair of the parliamentary committee, at a press briefing. "To have bonds we would need to change the EU treaty."
A solution for Ireland?
Despite the success of municipals in the US, and enthusiastic take-up of Build America Bonds, a proposal by Stephen Kinsella, lecturer in economics at the Kemmy Business School at Limerick University, that municipal bonds could help Ireland's recovery has so far fallen on deaf ears. Mr Kinsella argues that municipal bonds are the solution for Ireland's cash-strapped local authorities, inadequate pension provision and reduced infrastructural development.
He says that Ireland's local authorities have been systematically underfunded for decades; now, the parlous state of the country's economy means the government will have to reduce capital spending provision on many crucial projects that would help the economy get back on its feet, such as broadband provision, roads, and port systems.
His proposal lays out how municipal bonds could recapitalise local and regional authorities, while simultaneously increasing private provision of savings and pension entitlements. (Mr Kinsella says that of the country's 1700 defined-benefit schemes, about 400 are less than 50% funded, and a full 1500 are below the 100% threshold.) Local authorities would then be freed up to look at reducing other money-generating schemes, such as rates and parking charges, becoming more business-friendly and increasing inward investment by private business - at the same time as providing world-class infrastructure.
Earlier this year, Mr Kinsella was invited to present his ideas to the Strategic Policy Committee on Finance at Dublin City Council. Any hope that his proposal was gaining support was quickly dashed. "The Dublin Department of Finance killed the idea," he says. "As things stand, any debt raised by local authorities or municipalities simply adds to the stock of Irish government debt. Although we have issued such bonds in the past - so the precedent exists - I was told it would require legislative change to develop a municipal market; and there is no sign of that happening."
First steps
In the UK, however, the first tentative step has been taken towards reviving a local authority debt market that was squashed in the 1980s by Margaret Thatcher's Conservative government. After several city councils ran up huge debts - seen by the then government as the political hijacking of local authority finances - long-term local government funding was largely centralised under the auspices of the Public Work Loans Board (PWLB), an on-balance sheet lending vehicle. In September, the UK's coalition government introduced radical new powers aimed at funding local investment and economic growth through local borrowing.
The move paves the way for councils to utilise tax increment financing (TIF) - a method of raising private capital against future taxes that is already popular in the US. It allows councils to fund regeneration and development projects and repay investors with the newly generated local business taxes.
The final details were due to be released in the UK government's October spending review, after The Banker went to press, but early signals suggest that there is a great deal of enthusiasm from issuers. Following a call for expressions of interest from the government, 82 local authorities submitted 124 proposals to pilot TIF schemes, including large-scale initiatives in Birmingham, Leeds and Sheffield, as well as in London, where the city's mayor wants to use TIF to help push through a £600m ($950m) extension of the London Underground's Northern Line.
Robert Robinson, a director at financial advisory firm Bridgecourt & Company, which specialises in the local government sector, says there is plenty of appetite from lenders, too, for both municipal debt and TIFs. "Institutional investors would be natural lenders to long-term muni obligations, and banks appear to be in the frontline regarding TIF investments, where there are some analogies with private finance initiatives," he says.
Much of the detail is still unknown, however, not least the way 'additional' council tax revenue is calculated. The TIF model has been criticised in the US for funding projects that would have happened anyway (thereby not fulfilling the additionality clause) and for favouring developments such as shopping malls, which have been accused of simply moving economic activity around. Some have suggested that the use of TIF in the UK could be restricted to infrastructure and the regeneration of deprived areas.
Crucially, Mr Robinson believes that the proposal may miss an opportunity to get such local borrowing off the central government balance sheet. "What would make this a really exciting development is if there was real transfer of risk to the capital markets, but my understanding is that it will be local authority obligation, so if the TIF goes wrong, investors will be protected and local government will be on the hook."
One alternative, he says, is a kind of wrapper by which the government would take the first loss portion of the debt. "That way, private finance could take 90% of the risk and government take 10%, for example," says Mr Robinson.
There are barriers to the development of the market, however, not least that borrowing from the PWLB is at rates much lower than would likely be possible from financial markets. So unless central government shuts the door to such borrowing, there will be little incentive for local authorities to seek private capital.
The PWLB regime also means that today's local authorities have grown up with centralised government borrowing, and many lack the skill-set required for accessing private capital. Mr Robinson suggests that, like the PFI market, borrowers are unlikely to do more than one TIF-backed development scheme, so could use specialist advisors to help them structure such issues.
The road ahead
But just as many European policy-makers and bankers look to US models, municipal and TIF markets there are under increasing strain. The foreclosure on a Cleveland shopping centre and hotel property following missed mortgage and debt service payments on $6m of outstanding TIF debt, for example, is seen to have implications for other TIF-backed borrowings across the country.
As part of the case, the bond trustee, US Bank, has argued that a future owner should be required to continue to make debt payments under the original TIF financing agreement, which features additional security (minimum service payments tied to a mortgage) that ensures TIF payments are sufficient to cover debt service regardless of the property's valuation. The outcome of the case is being eagerly watched by holders of other TIF-backed bonds, who fear that declining real-estate valuations could mean TIF payments are insufficient to meet debt service payments.
The next crisis?
Some are predicting that the huge municipal market itself could be where the next financial crisis strikes. In his annual letter to shareholders in 2009, chairman and CEO of Berkshire Hathaway, Warren Buffet, warned that public officials may be tempted to default on bonds whose payments are guaranteed by insurance companies, rather than push through unpopular tax increases. He said insurance of municipal bonds against default "has the look today of a dangerous business".
Mr Buffet's view of the market has not improved. Berkshire has trimmed its municipal debt holdings from $4.7bn at the end of 2008 to less than $3.7bn now. At a hearing of the US Financial Crisis Inquiry in New York in June, Mr Buffet predicted a "terrible problem" for the bonds in coming years and said it will become a question of whether or not the federal government will help.
An avalanche of investors has sought refuge in the $2800bn sector in recent years, attracted by the stable and tax-free nature of muni bonds. According to the Investment Company Institute, more than $69bn flowed into long-term municipal bond mutual funds in 2009, up from only $7.8bn in 2008.
But in the 12 months to July 2010, 207 municipal issuers defaulted on bonds valued at $6bn; many expect that number to escalate, particularly with so many US cities suffering in the economic slowdown. In May, former Los Angeles mayor Richard Riordan argued in an editorial in the Wall Street Journal that the city will have little choice but to declare bankruptcy between now and 2014. Several smaller cities, including Harrisburg, Pennsylvania and Jefferson County, Alabama, have already talked about filing for Chapter 9 bankruptcy.
The US municipal market is also under attack by the Securities & Exchange Commission (via the Municipal Securities Rule Board); it has proposed a draft rule which would bring to an end the ability of broker-dealers to be both financial advisor and underwriter on a single bond issue. Many believe this would limit the number of bids - particularly on issues from smaller municipals - and reduce choice and liquidity for issuers just when they really need it.
The road ahead looks less than smooth for sub-sovereign issuers on both sides of the Atlantic.
