The worst year for municipal bond investors since 1999 may further reduce demand for tax-exempt debt just as state governments face the biggest budget deficits in at least a quarter-century.
State and local borrowers sold $385 billion of long-term bonds through yesterday, down 9 percent from 2007, according to data compiled by Thomson Reuters. Next year, sales will drop more than 6 percent to about $364 billion, the least since 2004, based on an average of estimates from London-based Barclays Plc, Merrill Lynch & Co. and Loop Capital Markets LLC.
The combination of the worst financial crisis since World War II and the collapse of the $330 billion auction-rate debt market will leave 41 states and the District of Columbia with shortfalls just as financing sources diminish. Merrill Lynch’s Municipal Master Index, which tracks 14,000 bonds, fell 4.6 percent this year, the first decline since a 6.34 percent drop in 1999. The biggest underwriters are merging or leaving the business.
“It’s been an absolutely horrible year,” said Robert MacIntosh, a money manager at Eaton Vance Management in Boston, who oversees $17 billion in tax-exempt bonds. He said he’s never seen such turmoil in the $2.67 trillion municipal debt market during more than 25 years in the business.
A freeze in global credit markets this year drove municipal borrowing costs to unprecedented levels. Yields on AAA general obligation bonds due in 30 years rose to a record 2.2 times Treasury yields from the historical average of about 0.96 times, according to Concord, Massachusetts-based Municipal Market Advisors. That represents an extra $2.93 million a year in interest on every $100 million of debt sold.
The lowest-rated borrowers were hit hardest. Merrill Lynch’s index tracking debt ranked BBB, the bottom tier of investment-grade, fell 22.3 percent, the most since the firm began compiling the data in 1989. Five of the 12 largest municipal-bond underwriters, including New York-based Merrill Lynch and Zurich-based UBS AG, agreed to merge or have exited the business.
Budget analysts are increasing their estimates of state deficits as the U.S. economy enters its second year of recession. The Center on Budget and Policy Priorities in Washington, a non-partisan budget and tax analysis group, said last week that states faced a combined budget shortfall of $42 billion this fiscal year, up from $8.9 billion on Oct. 10.
“It’s going to be very hard to get refundings done, at least in the first part of the year,” said Evan Rourke, part of a team that manages $7 billion in municipal bonds at New York- based M.D. Sass Associates.
This month, top-rated Harvard University in Cambridge, Massachusetts, sold tax-exempt bonds due in 2036 at a yield of 5.8 percent, or 1.31 percentage points more than similar securities it issued in June.
New York City offered investors 6.25 percent on bonds due in 20 years, up 1.65 percentage points from December 2007. Cascade Healthcare Community’s yields shot up more than 3 percentage points in seven months to 8.5 percent, as the Bend, Oregon-based hospital’s ratings were cut, in part because of higher debt costs.
Rising bond expenses are forcing municipalities to postpone projects. Merrill Lynch estimates the backlog of offerings to fund public works has grown to more than $120 billion.
The school district in Fort Bragg, California, a town of 6,600 located 170 miles (273.5 kilometers) north of San Francisco on the Pacific coast, put off construction at its high school and delayed a solar-power project after shelving a $7 million bond sale when interest rates jumped following the collapse of Lehman Brothers Holdings Inc. in September.
“It got really crazy right about the time we wanted to sell,” said Kathryn Charters, the district’s business manager, who hopes to issue the debt next year.
A total of $390 billion of bond sales are anticipated in 2009, said analysts Ivan Gulich and Chris Mier of Loop Capital, a Chicago-based underwriter. “Interest rates are the most important predictor of municipal bond volumes,” they said in a Dec. 18 report.
This year’s turmoil is a reversal from 2007, when sales reached a record $430 billion as hedge funds, banks and other institutions borrowed money to buy municipal securities and boost returns, according to Thomson data.
Analysts at New York-based Citigroup Inc. led by George Friedlander estimated in a Dec. 19 report that the amount being used by investors in that type of strategy fell to about $12 billion from a peak of $120 billion.
Losses started in February, when the auction-rate market collapsed as dealers who supported it for two decades abandoned the weekly and monthly sales where rates were set on the long- term bonds. Interest costs soared to 20 percent for issuers such as the Port Authority of New York & New Jersey when dealers stopped buying securities that went unsold.
At the same time, bond insurers that guaranteed more than 50 percent of all new municipal debt began suffering credit rating downgrades after standing behind the same subprime mortgage-related securities that have triggered $1 trillion in losses and writedowns at the world’s biggest financial institutions.
Instead of selling bonds to finance public works, issuers from California to New York were forced to refinance auction- rate and other adjustable-rate securities with fixed-rate debt.
With demand drying up among institutions, state and local governments are turning to individual investors.
A marketing campaign by California, the biggest municipal borrower, helped draw a record of more than $3.9 billion of orders from retail investors in a $5 billion short-term note deal in October, according to the state treasurer’s office.
“Issuers should not presume that market access will necessarily be available on demand,” underscoring the need to cater to individuals, Phil Fischer, a municipal strategist at Merrill Lynch, said in a Dec. 8 report.
California officials said Dec. 11 the state’s shortfall will reach a record $41.8 billion over the next 19 months, and the state may run out of cash as soon as February.
A day earlier, Standard & Poor’s said it may lower the rating on California’s $46.6 billion of general obligation debt and $7.8 billion in bonds backed by lease payments. S&P reduced to “SP-2” from “SP-1” its ranking on $5 billion of short- term notes that the state sold to cover its tax shortfalls.
Public officials are pinning their hopes for a turnaround on a stimulus plan of as much as $1 trillion being developed by President-elect Barack Obama. New York Governor David Paterson wrote in a Dec. 29 letter to Obama that he “strongly” supported spending $300 billion for “ready-to-go projects to rehabilitate and construct” infrastructure.
“We have got a huge infrastructure problem that will start to be funded in 2009,” said Kevin Giddis, a managing director of fixed-income trading with Morgan Keegan Inc. in Memphis, Tennessee, in a Dec. 29 interview with Bloomberg Television.
The fiscal insanity behind these plans is staggering. The mayors and state governors are getting in line for bailouts. They, too, appear unwilling to simply do what is asked of every single individual in society: Live within your means, cut your expenditures, consolidate your finances. Vallejo in California already declared bankruptcy in May this year way before the bailout surge spiraled out of control. Several more are expected over the next years:
After a disaster of a year, 2009 isn’t shaping up to be a walk in the park either. Sure, Option ARM resets will wreak havoc on defaults and foreclosure rates, but that’s the least of our concerns.
Now, the accountant (who predicted the 1994 Orange County bankruptcy) believes we’ll see up to 10 municipal bankruptcies in 2009. And if that happens, we could watch as the $2.7 trillion market for state, county and city debt is shattered.
In 1994, John Moorlach warned that Orange County, California’s investing strategies could wreck its finances. And he was right. Six months later, the county went bankrupt after losing $1.6 billion.
And he now believes that four cities in California and six others nationwide could seek court protection under Chapter 9 of the bankruptcy code in 2009.
But Moorlach may be too optimistic. Richard Ciccarone, a research officer, for example, believes we’ll see 36 bankruptcies over the next two years; 12 defaults in 2009 and at least 24 in 2010.
What is noteworthy that in light of this interest rates for new issues have recently actually dropped sharply and now appear to be approaching lower treasury multiples. This indicates that the market expects a significant decline in demand for new funding on the part of municipalities due to consolidation and more bankruptcies, and/or that investors no longer find municipal debt risky since they are expecting a bailout from the Obama administration. Most likely it is a little bit of both that is pushing yields down at this point. This is in line with phase 8 of the business cycle.