For years, the capital-raising strategies of cities and towns across the US, and even big states such as California and Illinois, received little attention. Their bond sales typically went off without a hitch and involved borrowers, dealers and investors who operated in an isolated corner on the sidelines of the credit markets.
Recently, though, the twists and turns of the $3,000bn municipal bond market have moved to the front of the minds of investors, lawmakers and Wall Street pundits. A recent strategy report on the US stock market from Bank of America Merrill Lynch was titled, “Munis: another wall of worry”.
Meredith Whitney, the analyst who rose to fame for predicting trouble at some large US banks ahead of the financial crisis, last month called the financial woes of state and local governments “the single most important issue in the US, and certainly the largest threat to the US economy”.
Ms Whitney, in a national television broadcast, predicted “50 to 100 sizeable defaults” totalling “hundreds of billions of dollars”, a level unheard of for a market hitherto perceived as a safe place to invest.
At the heart of the newfound concern is a confluence of events stemming from what is being called the Great Recession, which revealed years of fiscal mismanagement by state and local governments, and a credit crisis that has reshaped large sections of the financial markets – including municipal bonds.
“States were ill-equipped to deal with the effects of the Great Recession, which caused tax revenues to fall and budget gaps to widen to levels that ... require austerity measures,” says Michael Zezas, a municipal debt strategist at Morgan Stanley.
All states apart from Vermont have to balance budgets annually and they have been forced to deal with collective deficits of $388.1bn since 2008, according to the National Conference of State Legislatures, a bipartisan research group.
This strain has led to big cuts in spending on libraries, social welfare programmes, parks, infrastructure and education. There are concerns that some local entities may struggle to pay their debts.
“At 11 per cent of real US gross domestic product, state and local credit weakness negatively impacts the US economy,” says Mr Zezas. “Sizeable expenditure-cutting represents a drag on US economic recovery and is a risk to earnings of companies which provide capital expenditure services to local governments.”
The state of Illinois agreed to raise the personal income tax rate from 3 per cent to 5 per cent and business income taxes from 7.3 per cent to 9.5 per cent to help tackle a $15bn budget deficit, unfunded pension liabilities of at least $80bn, and more than $8bn of unpaid bills to educational institutions and social welfare providers.
With a nascent national recovery, state tax revenues are picking up, but they remain well below pre-recession levels. Fiscal analysts say that modest growth will be insufficient to outweigh the fall in federal stimulus money this year and deficits are likely in some areas for years to come.
Budget pressure has coincided with shifts in the municipal market. Before the financial crisis, about half of new issuance was insured with triple-A guarantees. But the bond insurance industry collapsed after monolines such as MBIA and Ambac faced steep losses on risky mortgage debt they also insured.
Investors, mostly individuals who benefit from tax breaks, face a changed landscape if they want to stay in municipal bonds. Gone is the commoditised, largely triple-A market – investors will now have to analyse individual bonds from a universe of at least 50,000 states, cities, towns, school districts and local sewer authorities.
And, because they are not regulated by the Securities and Exchange Commission, local governments and other public entities do not have to disclose the same information as corporate issuers.
Municipal borrowers have also lost the benefit of the Build America bonds programme, a crisis-era, federal subsidy for taxable infrastructure bonds that expired at the end of 2010. The scheme drove a drop in borrowing costs, as it directed some financing needs to deep pocketed institutional investors.
Muni bond experts concede that defaults will rise, but they dismiss warnings of a meltdown. Even bears say states will be able to honour their obligations, but cities and towns are more of a wild card, especially because they rely on states for a chunk of their revenue – and states have been forced to make cutbacks.
“The muni market is uniquely built upon its own credit,” says Jason Pride, director of investment strategy at Glenmede, a wealth management firm with more than $19bn of assets under management. “That is far more of a concern.”