By Yali N’Diaye
WASHINGTON (MNI) – Rating agencies have also emphasized the risk of
a downgrade, rather than default, as the biggest risk to municipalities.
Moody’s said it “expects that no state will default on its general
obligation debt,” adding that “At the local government level, defaults
are likely to increase modestly, but are expected to be neither
widespread nor systemic.”
Another major rating agency, Standard & Poor’s, even estimates that
“a majority of state and local government issuers rated by Standard &
Poor’s will likely remain medium to high investment grade.”
A “significant credit deterioration,” according to Fitch, “would
likely be over multiple years.” It added that downgrades, rather than
defaults, are more likely to be the biggest risk to municipal credit in
2011.
That said, defaults are clearly a threat.
Many municipalities and smaller issuers for instance do not benefit
from a tax authority, putting them at a higher risk of default.
And some revenue bonds that are particularly sensitive to economic
conditions are also at risk given how weak the recovery has been.
In particular, land and housing-backed bonds are the most at risk,
especially for issuers that came to the market between 2005 and 2007.
With the economic recovery still uneven and real estate struggling,
revenues are affected — especially property tax revenues — which
account for a large share of municipalities receipts.
On the other hand, essential services revenue bonds tend to have
strong ratings and are favored by investors.
Still, the message overall from investors and analysts is that
while defaults for municipal issuers are higher than they have been
historically, they remain low and are not a systemic threat.
Turning to supply, the trends are supportive.
SIFMA’s co-Head of its Municipal Securities Division Michael Decker
said in a recent interview with Market News International that supply so
far has been rather thin in the muni market, and he expects it to remain
that way this year.
While muni borrowers are taking advantage of attractive yields,
Decker said we are unlikely to “see a spike in issuance that will lead
to the kinds of volumes we saw last year.”
Besides, Build America Bond issuance last year boosted supply,
allowing municipalities to move forward in financing their projects.
They can now remain on the sidelines.
And finally, spending control is slowing projects, creating a need
to finance them using alternative methods.
On the demand side, investors are looking for yield but remain
cautious amid global sovereign debt fears.
Municipal Market Advisors Managing Director Matt Fabian warns that
“any breakdown in demand at present could mean strong underperformance.”
So while it remains to be seen how supply will be absorbed,
especially when headline fears re-surface, the thin supply will be
supportive.
One of the many other factors at play is tax policy, which is
especially relevant to muni bond investors.
On the positive side, the end of the Bush-era tax cuts will
translate into higher taxes, with the top bracket especially exposed,
and that is supportive of demand for tax-exempt bonds.
This will only hold true, however, so long as the federal tax
exemption of interest earned on muni bonds is maintained.
With the debt limit hike debate and the focus on restoring a sound
fiscal position in the U.S., an overhaul of the tax code has also been
targeted by lawmakers, with a growing push in favor of taxing all
interests on municipal bonds.
On the Senate side, the Wyden-Coats proposal (S. 727: Bipartisan
Tax Fairness and Simplification Act of 2011) was introduced on April 5
and has been referred to the Senate Finance Committee.
The bill proposes that muni bond issuers lose the tax-exempt status
of their bonds, and instead receive a federal subsidy to lower their
interest rate cost. Interest on state and local debt would become
taxable after 2011.
On the House side, Representative John Tierney said in April he
would introduce the Tax Equity and Middle Class Fairness Act of 2011 to
“terminate nearly 30 tax expenditures.”
The bill, however, has yet to be introduced.
The proposals would grandfather existing bonds, increasing the
likelihood that a two-tiered market between existing bonds and new bonds
will be created, with existing bonds benefitting from a very strong
demand.
The National Commission on Fiscal Responsibility in December 2010
also proposed making interest taxable as income for newly-issued muni
bonds.
Finally, and adding further support to this approach, a study by
the Congressional Budget Office estimates that tax exemption for state
and local borrowings will cost the federal government $161.6 billion
from 2010 through 2014.
The elimination of the federal tax exemption would likely bring in
more institutional investors — similar to what occurred with BAB
issuance — since the tax advantage would no longer be a primary driver
for investment decisions.
It is unclear, however, whether the shift in the investor base
would translate into a larger muni market or not.
Still, the elimination of such a tax advantage is far from becoming
a done deal and if it were to happen, it would not be a near-term
change.
The legislative process would likely take months if not years, as
municipalities, not to mention the financial industry, would fight any
attempts to eliminate the federal tax exemption.
So isolated defaults is the most expected scenario among investors
and analysts.
But vigilance is needed and it will be important to follow
legislative developments in relation to the tax code.
Land-backed bonds are especially at risk given the ongoing weakness
of the housing market combined with the weakness of the issuers’
creditworthiness.
Against this backdrop, headline risks remain in the form of new
dire predictions such as those made by analyst Meredith Whitney, or
through new state and local governments budget developments.
For PIMCO, the repricing risk is the biggest risk facing the muni
market, not default risk.
And finally, it remains to be seen how the muni market will react
to a rising interest rate environment down the road and possibly higher
inflation.
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** Market News International Washington Bureau: 202-371-2121 **
[TOPICS: M$U$$$,M$$FI$,MGU$$$,MFU$$$,MT$$$$]
