The Weak Get Weaker as Muni Bonds Are Sold Off

By TOM LAURICELLA And JEANNETTE NEUMANN

Amid the recent selloff in the municipal-bond market, investors are increasingly differentiating between state and local governments with strong finances and those facing big fiscal woes.

That trend could have significant implications for holders of bonds issued by weaker state and local governments, some of which are already paying higher interest rates and have seen the prices of their bonds decline in value.

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The growing gap between what the strongest and weakest government issuers pay to borrow brings unpleasant echoes of the European debt crisis, where escalating yields paid by countries such as Greece and Ireland made their fiscal situations untenable.

For muni investors, the scenario could prove similar—a series of rolling crises as the spotlight goes from one troubled issuer to the next.

Underlying this dynamic are issuers struggling not just with budget woes but with higher borrowing costs that end up inflating budget deficits. That prompts still more borrowing and also can result in ratings downgrades that can further raise borrowing costs.

“It’s a downward spiral,” said George Rusnak, national director of fixed income for Wells Fargo Private Bank.

Editors’ Deep Dive: Rocky Road for Muni Market

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The news isn’t great for investors in the $2.8 trillion municipal market, who include individual investors and property- and casualty-insurance companies, as well as more-recent investors, such as pension funds and foreign investors, attracted by a relatively new type of taxable muni bond.

Over the past month and a half, the municipal-bond market has taken it on the chin. The yield on 30-year, triple-A-rated municipal bonds closed at 4.66% on Friday, according to a widely watched index published by Thomson Reuters Municipal Market Data. That is up from 3.86% on Nov. 1.

The hardest-hit borrowers generally have been those seen as in the most dire fiscal shape. The market typically punishes creditors perceived as riskier by demanding higher yields. Some analysts anticipate yields paid by the most troubled municipal borrowers will only continue to widen next year in comparison with the broader market.

For Illinois, rated the worst in the country by Moody’s Investors Service at A1-negative, the gap between what the fiscally strapped state pays on its 10-year-maturity bonds is now 1.9 percentage points above that for the broader muni market. Just a month ago, the spread for Illinois stood at 1.6 percentage points, according to data from Municipal Market Data. A year ago, that gap was less than one percentage point. Spreads on Illinois bonds could reach as high as two percentage points next year, says Wells Fargo’s Mr. Rusnak.

State-by-State Variations

Nevada, which carries a slightly better credit rating of Aa1-negative from Moody’s and is seen as especially hard hit by the housing-market collapse, has seen its borrowing spread rise to 0.80 percentage point from 0.5 point on Nov. 1.

In comparison, Pennsylvania, which has the same rating as Nevada but whose fortunes are perceived by the market as relatively brighter, is paying just 0.2 percentage point above that of the broader muni market, about the same as it was both a month ago and in late 2009.

For states with greater perceived risks, “investors are asking to be compensated for it,” said Tom Kozlik, municipal credit analyst at Janney Capital Markets.

The potential for spreads to widen comes as some analysts expect the level of yields on muni bonds broadly to be on the rise next year. One big reason is the end of the Build America Bonds program, which helped the muni market by diverting some $150 billion in issuance into the taxable-bond market.

Bank of America Merrill Lynch, for example, expects muni yields to rise 0.35 to 0.50 percentage point without the program.

In the case of Illinois, which sold $10.9 billion in longer-term debt in 2010, an extra 0.35 percentage point on its debt would have meant an extra $38.2 million in interest payments.

Could Problems Spread?

A key unknown for investors is whether severe financing problems will remain isolated to individual struggling issuers or instead spread to healthier issuers.

John Longo, investment strategist at advisory firm MDE Group in Morristown, N.J., thinks that as long as any defaults remain few and far between, the impact will localized to those issuers. However, “if there are many defaults, it could result in a macro, contagion-type risk,” Mr. Longo said.

Comparisons to Europe are ill-placed, said John Sinsheimer, director of capital markets for Illinois, because Illinois doesn’t roll over its debt in the same way some European countries do. “In Illinois, all our debt is paid off like clockwork every year,” Mr. Sinsheimer said.

There are other differences between the European government-bond market and munis. For example, local governments can try to turn to their states for support, and there are existing frameworks for municipalities to work through restructurings.

Janney’s Mr. Kozlik notes that there also has long been the option to sell so-called deficit-reduction bonds, as Massachusetts did in 1990 to bridge a huge budget deficit. However, he notes, such bonds will still cost an issuer more money in interest.

On the flip side, the European bond market has been propped up by bond purchases by the European Central Bank. Analysts say they can’t recall a large-scale purchase of muni bonds by the Federal Reserve, and the law limits the Fed’s ability to buy muni debt to only certain kinds of very short-term securities. However, some in the market speculate that, should a third round of quantitative easing—injecting cash into the market through bond buying—become needed to boost the economy, the Federal Reserve might buy munis.

The big question is whether the recent muni selloff will continue. Some of its catalysts could prove transitory, such as the rise in U.S. Treasury yields, which long-term munis tend to track. In addition, a burst of heavy selling by mutual-fund investors came close to the year’s end, just as Wall Street brokerage firms are trying to keep inventories of bonds on their books as low as possible

But 2011 could see increasing strains on state and local governments’ balance sheets. That is partly because of expectations that the job market will remain weak, depressing revenues brought in from payroll taxes and making it politically unpalatable to raise taxes on unemployed residents.

Diminishing Collections

At the same time, property taxes are “poised to decline” in coming years, the Congressional Budget Office said in a report this month. That is because homes aren’t reassessed every year, so local property-tax revenue lags behind falling house prices by three years on average. “Even small declines in collections could cause fiscal stress when the cost of providing public services is growing,” the report said. Also, state aid to local governments has already declined in many states and is expected to be cut by more states next year.

This is no small issue. Towns and cities rely on property taxes for nearly one-fourth of their revenue and state aid for another third, according to the CBO.

“Municipalities are going to be doing belt tightening, but there’s only so much belt tightening they can do,” said MDE’s Mr. Longo. If they are hit with higher borrowing costs and lower property-tax revenues, “that becomes an unsustainable position.”

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