A muniland outlook for 2014

January 3, 2014

After taking a look back at 2013, here are my predictions for muniland in 2014.

The biggest muniland story this year will be the development of the Chinese municipal bond market. It’s not often that you get to watch a government launch a bond market. And China’s will be massive. From the South China Morning Post:

The [Chinese] mainland’s quest to solve its $3 trillion-and-growing public debt problem by starting a domestic municipal bond market hinges on the one thing officials are most afraid of: transparency.

As markets absorb the results of the latest audit of state finances, Beijing’s long-standing vow to develop a municipal bond market to curtail rapid growth in other types of hidden public debt will take centre stage once more.

By letting local governments sell bonds for cash, Beijing wants to rely on nimble markets rather than inflexible regulations to keep spendthrift units in check.

The stakes are high. A bond market is the centrepiece in a blueprint to mop up fiscal troubles and keep the economy growing at an even pace, giving it room to start other financial reforms.

The U.S. will experience moderate economic growth and state government revenues will be up positively in 2014, but not as sharply as 2013’s 9 percent. Local government revenues will increase more slowly. The Rockefeller Institute says that local revenues increased an average 2.3 percent for the four quarters ending June 2013 (page 3). This is weak by historical standards and will likely continue in that range.

Labor costs, which are on average about 70 percent of state and local government expenses, will continue to rise modestly. Increases could be offset by a shrinking public workforce.

Muniland will continue to be concerned about potential federal tax reform in 2014. Naomi Jagoda of the Bond Buyer has an excellent summary of federal tax legislation for the House Ways and Means Committee and the Senate Finance Committee, which are responsible for the tax code. Some leadership changes make the direction of tax reform very hard to predict. From Naomi’s article:

Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University, said that two potential wild cards for tax reform in 2014 are the budget resolution for fiscal 2015, which may include instructions for tax reform, and the need for another debt ceiling increase, which may spur discussion of taxes.

Most market participants think President Obama will continue to include a 28 percent cap on the value of the tax-exemption for munis in his fiscal 2015 budget, which is supposed to be released in February.

Many expect municipal bond issuance to continue to decline due to budget pressures. Dealer group Sifma published its 2014 Municipal Bond Issuance Survey:

Survey respondents expected total municipal issuance, both short- and long-term, to reach $349 billion in 2014, down from $366 billion estimated issuance in 2013.  Both short-term and long-term issuance is expected to fall in 2014, with $40 billion in short-term notes expected in 2014, compared to $53 billion issued in 2013; and $309 billion in long-term bills expected in 2014, compared with $312 billion issued in 2013.

Everyone sees interest rates moving up. Sifma surveyed market opinions and found:

Survey respondents offered relatively uniform views on interest rates in the coming year. The federal fund rate was expected to remain unchanged in 2014. Forecasts include:

  •  Two-year Treasury note yield was expected to rise from 0.34 percent end-December 2013 to 0.69 percent by end-December 2014.
  •  10-year Treasury note yield was expected to climb from 2.77 percent end-December 2013 to 3.5 percent end-December 2014.

Mutual funds will continue to suffer outflows from higher interest rates.

Regulatory issues will change the dynamics of municipal bond underwriting. For example, the Bond Buyer had an important story by Keeley Webster about Los Angeles barring securities underwriters from bidding on financial advisor jobs (clearly a potential conflict of interest):

Los Angeles is seeking financial advisors for bonds issued in several categories, but underwriters need not apply, according to two recent requests for proposals issued by the city.

First Southwest sent a seven-page letter to Los Angeles officials Friday protesting the language in two RFPs seeking financial advisors but excluding firms ‘that underwrite or otherwise trade in municipal bonds.’

That language appears in the qualifications section of an RFP seeking a financial advisor to work on the city’s general obligation bonds and wastewater system revenue bonds.

The biggest risk to muniland will be Puerto Rico. I and others including Blackrock’s Peter Hays believe that Puerto Rico may have to restructure its debt within the next six months. The Commonwealth announced on Thursday that it will issue new long-term debt by February. But market yields are so high that even a third lien Cofina (“Sales Use Tax” bond) would have to be above 8 percent; a prohibitively high municipal bond interest rate.

Muniland will look different at the end of 2014. Everyone must push for more transparency and timely reporting by issuers. New market players will want better disclosure than many issuers and market participants are accustomed to. The majority of municipal issuers will have no problem raising debt, but highly indebted issuers will have to pay proportionally higher rates to borrow. Fasten your seat belts.

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Anything is possible but this is only the extreme end of a spectrum of possibilities:

With the darkest view of Puerto Rico bonds, BlackRock’s Managing Director and Head of Municipal Bonds Group Peter Hayes told Fox Business News that the Commonwealth may have to restructure its debt “somewhere between now and the middle of 2014 when their fiscal year begins.”

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