US municipal bond market resists the crunch

When Meredith Whitney, an analyst who made her name with a scathing report on Citi’s financial position in October 2007, predicted hundreds of billions of dollars of defaults in the US municipal bond market, investors took notice. Between her call in December 2010 and August 2011, municipal mutual bond funds experienced net outflows of about $50bn.

This was despite defaults in the market, which today has about $3700bn of bonds outstanding, historically being rare. Moody’s counts just 71 between 1970 and 2011. This compares with 1784 in the US corporate market, which is double the size of the municipal one.

But for many investors in the so-called 'muni' market, Ms Whitney’s doom-laden forecast made sense. With US unemployment having soared from 4.5% in mid-2007 to almost 10% in 2009, it seemed inevitable that plenty of state and local governments would fail to pay off their debts.

Fears allayed

Two years on, Ms Whitney’s prediction has not even come close to being realised. In all of 2011, there were only about $1bn of defaults in the muni market, while the figure for the first half of this year was roughly $600m. Sentiment among investors has strengthened accordingly. In the 12 months from September 2011, there were $40bn of inflows into mutual funds.

“Flows into municipal bond funds have been very strong, as strong as they’ve been in a long time,” says Tom Henson, head of public finance at Philadelphia-based financial services firm Janney Capital Markets. “People who talk about the potential demise of the muni market don’t have a very good understanding of how the system works with local governments.”

High demand for muni bonds has led to their spreads tightening, even as issuance has increased over the past year. In 2012, analysts expect a total of $365bn to $380bn of such debt to be printed (almost $330bn-worth had been after the first nine months), compared to just less than $290bn in 2011. But yields on AAA rated municipal bonds – which are usually expressed as a percentage of those on US Treasury bonds with similar maturities – came in from 107% in January to about 104% in mid-October.

Pimco, one of the world’s biggest bond investors, which has more than $60bn of exposure to muni securities, has been among those with a bullish stance. “We have been pretty aggressive buyers in the market in the past six to nine months,” says Joe Deane, its head of municipal bond portfolio management.

California blues

The performance of the market in the past two years exemplifies its inherent strengths in comparison to the corporate bond market. Particularly important is the fact that local and state governments have the ability to raise taxes to meet their obligations, while many also have far stricter rules on balancing their budgets than the federal government does.

“People were scared when they saw the headlines in the fourth quarter of 2010, with some saying there would be hundreds of billions of dollars of defaults,” says John Bonnell, a portfolio manager at USAA Investment Management. “What they learned after that was that while state and local governments have issues, budget pressures do not necessarily equate to bond defaults.”

Still, economic weakness in the US in past three years has put municipal bond issuers under plenty of strain, especially with revenues from income, property and consumption tax having fallen. Chris Mauro, head of US municipal strategy at RBC Capital Markets, says that while he does not expect default rates to rise substantially in the foreseeable future, many local governments are struggling. “There is no question that they are, by and large, under significant budgetary stress,” he says. “And they will continue to be until we see improvements in employment and personal income levels. Those are the two underpinning drivers of local government revenues.”

Exemplifying these problems, three cities in California – Stockton, San Bernadino and Mammoth Lakes – filed for Chapter 9 bankruptcy, the one applicable to municipalities, in the space of a few weeks earlier this year. California, the most populous state in the US, suffered a particularly bad housing slump and saw unemployment, which still stands at more than 10%, peak at 12.5% in mid-2010.

Willingness versus ability

While those filings represent a very small proportion of the Californian municipal market, let alone that of the US as a whole, investors are concerned that they might be reflective of issuers believing that bankruptcy is a feasible option for dealing with their debts. These fears were heightened when Moody’s said in August that some municipalities were considering bankruptcy as a new strategy to address their deficits and that it expects “more bankruptcy filings and bond defaults among California cities... as investors are asked to contribute to plans for closing budget gaps”.

USAA Investment Management's Mr Bonnell addresses the issue of willingness. “It is concerning when you see headlines [such as those coming from] Stockton," he says. "That process is just beginning and we have to wait and see how it plays out in the courts. But it raises the whole issue of willingness to pay, which used to be a given in the municipal market. It used to be just a matter of looking at an issuer’s ability to pay.”

Even so, bankers believe Californian issuers are anomalies. The state has among the most restrictive laws in the US when it comes to allowing local governments to put up taxes. California’s Proposition 13 – which requires two-thirds of legislators to agree to any hikes in state taxes, including income tax – places particularly onerous limitations on its governments.

Gabriel Patek, a senior director in the state and local government ratings group at Standard & Poor’s (S&P), says that this often means that tax increases are ruled out as an option when municipalities there are faced with falling revenues. “All the fiscal management is done on the cutting side,” he says. “If they have a shortfall, they have to make cuts.”

Peter DeGroot, JPMorgan’s head of municipal research, says that the filings have not even had that much of an effect on California’s wider muni market. “Broadly speaking, investors weren’t significantly impacted by the recent filings among local California issuers,” he says. “The vast majority of the municipal buyer base has viewed those situations as idiosyncratic and specific to those individual issuers, as evidenced by 30 consecutive weeks of net inflows into California state municipal bond funds.”

Stigma of Chapter 9

Moreover, analysts believe that the stigma attached to a municipality that files for Chapter 9 is such that the majority would want to avoid the outcome at all costs. “Once a municipality opts to file for bankruptcy, it shows their willingness is compromised,” says Mr Patek. “They will not automatically see their perceived willingness to pay restored [in the eyes of investors] once they emerge from bankruptcy.”

S&P said in a report in October that bankruptcy “contributes to the longer-term degradation of an obligor’s economic fundamentals and tax base largely because of what the municipality can no longer do, such as maintain its infrastructure and service levels”.

Bankers cite the fiscal management of governments across the US in the past four years as evidence that they intend to meet their commitments in the bond market. Since August 2008, state and local authorities have reduced their workforce by 715,000, or just more than 3.5%, reversing a trend that saw their payrolls getting bigger. Although some economists have argued that this, combined with other austerity measures, will stifle growth in the short term, most believe it is necessary for municipalities to address their fiscal weaknesses directly rather than trying to spend their way out of their slumps.

Investors say that with interest rates in the US so low, it was not inevitable that municipalities would choose to narrow their deficits in the short term. But most have, with new money bonds having been slashed as a proportion of overall issuance. Whereas before they used to make up the bulk of supply, the debt printed in the muni market over the past two years has tended to be for refinancing purposes. “You have got to give [the local governments] some credit,” says Pimco’s Mr Deane. “Even with very low interest rates, they have been trying to tighten their belts and issue less debt.”

Others add that the policies adopted by municipal borrowers should be enough to ensure that defaults do not rise significantly in the foreseeable future. “I think default rates will remain pretty much where they are today,” says RBC Capital Market’s Mr Mauro. “The vast majority of local governments are managing their affairs in an appropriate way. Some are doing innovative things such as sharing costs or services with neighbouring local governments.”

Under strain

Investors are less sanguine, however, about municipalities’ unfunded pension liabilities. These used to be more or less ignored by participants in the market, but are now starting to come under scrutiny, with some rating agencies saying that annual contributions at the state level need to go up by tens of billions of dollars to close the gap.

“The biggest difference in our market from five or 10 years ago is the unfunded pension liabilities that are cropping up,” says Mr Deane. “This was probably something that people didn’t even talk about 10 years ago.”

The balance sheets of US municipal bond issuers are likely to be under strain for at least the next two years. Even if recent signs of an economic upturn prove lasting, the US’s recovery, and particularly a reduction in unemployment to pre-2008 levels, will likely be a long process.

Nonetheless, the market seemingly believes municipalities will be able to cope. The tightening of spreads this year suggests that the fears among some investors in late 2010 no longer prevail. “If we don’t go in to a meaningful recession – if we just muddle along at 2% or 3% growth – I think most states and municipalities will be able to manage their way through,” says Mr Deane. “If you have got a massive downturn, [such as the one] at the end of 2008 and [into] 2009, that is something quite different. But I don’t think we as a firm anticipate that.”

More tightening?

Several bankers feel that yields in the municipal bond market have tightened on an absolute basis to such a point that they are unlikely to narrow further. “In the past two or three years, we have had double-digit returns,” says Mr Bonnell of USAA. “Can it continue? I wouldn’t expect so, given that absolute rates are so low. There is only so much further they can go before they are at zero.”

But many feel that, on a relative basis, muni bonds can still tighten. The top-rated ones have traditionally traded inside US Treasuries, given that the interest on them is exempt from federal and state income tax (which makes them attractive to retail buyers, who make up about half the muni bond investor base). As such, with AAA municipal bonds trading on average today at about 104%, they will not necessarily widen automatically should US Treasury yields increase.

“As long as rates stay low, we are going to see [municipal] spreads staying in their current range,” says Janney’s Mr Henson. “If rates increase, I think the spread between Treasuries and munis could move back to its traditional range of 86% to 88%. The reason that spread is higher is because rates are so compressed right now.”

The tax exemption on municipal bonds, which does not apply to federal debt, has long been one of their most attractive features for retail investors and will continue to draw such buyers to the market. “There are very few tax havens in the US, and this is one of them,” says one debt market banker.

Nonetheless, states and local governments show few signs of complacency and seem intent to clean up their finances quickly. The likely consequence is that the muni bond market will continue to be dominated by refinancing-related supply in 2013. And while bankruptcy filings similar to those seen in California this year might become slightly more common, investors are scarcely fretting. “We are starting from such a low number,” says Mr Bonnell. “Even if we have [default rates] 10 or 20 times higher than we had in the past, it would still be a low number.”