Greg Ip

Articles by The Economist’s U.S. Economics Editor

America’s municipal-bond market: State of pay

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Dec 10th 2009 | WASHINGTON, DC
From The Economist print edition

A federal subsidy may change the market for good

 
 

 

[Greg Ip] THE federal government may have astronomical deficits but it can still borrow with ease at rock-bottom rates. Not so states, municipal governments and other government agencies, such as school districts and public-transport bodies, which have historically borrowed at lower rates than the Treasury. That is because interest on municipal bonds is generally tax-exempt. Investors accept a lower yield on a muni-bond than on a comparable Treasury bond on which they pay tax.

Thanks to the financial crisis, however, that position has changed: municipal yields are much closer to and, in some cases, above those on Treasuries (see chart). Some borrowers have scaled back or shelved planned borrowing. New Mexico usually issues short-term notes each year to raise working capital, investing some of the proceeds in higher-yielding federal securities. But that would be a money-loser at its current cost of borrowing. “We have been trying to issue (the notes) for almost a year and the market just wasn’t favourable,” says James Lewis, the state treasurer.

Multiple forces are at work. A desire for safety has made Treasury yields unusually low as investors have become more wary of state and local governments’ creditworthiness. States are on track to run up deficits of $190 billion in this fiscal year (to the end of June) and $180 billion in the next, according to the Center on Budget and Policy Priorities, a think-tank. Since almost all have balanced-budget laws, they will have to raise taxes or cut spending to keep those gaps from materialising.

The crisis has hurt liquidity in other ways, too. Todd Fraizer of Public Financial Management, a firm that advises governments on borrowing, says there are 12,000-15,000 muni-bond issuers, of which only 300 are large and well-known to most investors. The rest would often have their bonds guaranteed by AAA-rated bond-insurance companies, helping buyers sidestep painful due diligence. But many of the insurers have been laid low by their exposure to mortgage-backed securities, leaving just two firms to sell guarantees at less attractive rates.

That things are not even worse is the result of a federal initiative that could permanently change the municipal market. This year’s economic-stimulus legislation allowed states and local governments to issue taxable bonds and receive a federal subsidy equal to 35% of the bond’s interest. These “Build America Bonds” have been a hit, especially with big, weakened borrowers like California and New York. Some $58 billion have been issued so far, equal to 15% of this year’s municipal issuance, according to Thomson Reuters. Analysts at JPMorgan reckon that issuance could reach $110 billion next year.

The direct subsidy is far more efficient than the federal tax break on interest. The tax exemption often costs the Treasury more than the borrowers save on interest payments. It also makes the market smaller and less liquid by excluding investors (such as foreigners or pension funds) who do not pay federal tax anyway. And the exemption mainly affects wealthy taxpayers, who are unsure of its benefit because of a constantly changing tax code, says Howard Simons of Bianco Research.

The Treasury may extend the scheme past its scheduled expiry date at the end of 2010. If that happens, taxable bonds could eventually come to dominate the municipal market. Along with the scarcity of bond insurance, that could make life even harder for smaller borrowers whose principal appeal was their tax-exempt status.

The original story is linked here.

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Written by gregip

December 10, 2009 at 8:00 pm

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