Where did all the bonds go?

March 5, 2014

Long-term municipal bond issuance is shrinking. I don’t need to recite the numbers, just look at the chart above (from Sifma with data from Thomson Reuters).

Municipal tax-exempt bond issuance has been lower than 2008-levels for five years. I wrote last August:

There are many factors that are weighing on issuance, but the primary one is likely to be the higher rate environment. There are other factors like shrinking federal revenues due to sequestration and rising pension and healthcare costs for state and local governments. There has been more active pressure from rating agencies about future liabilities like pensions and a lot of uncertainty about the direction that Congress will take regarding capping the muni bond tax exemption.

Standard & Poor’s recently issued a comment piece that sheds more light on the shrinking municipal issuance story. They reviewed or rated 173 direct loan municipal deals totaling about $10.4 billion from 2011 through February of this year. After seeing these deals and talking with market participants, they estimate that direct bank loans to muniland might account for as much as 20 percent of new municipal borrowing. That would be roughly in line with my estimate in June, 2013:

I’ve heard numerous estimates that such issuers have outstanding bank borrowings in the $200 to $300 billion range, which would amount to approximately 5-8 percent of the $3.7 trillion municipal bond market.

Of course there are big risks to all bondholders when an issuer takes a bank loan that gets higher seniority. S&P again:

Private placements or direct-purchase obligations can have substantial implications for the credit quality of an obligor’s capital market debt, irrespective of how large or small the alternative financings might be relative to the balance sheet.

Implications can include, but are not limited to, acceleration and the potential for cross–default provisions between privately placed debt and capital market debt. Some documents contain events of default provisions or covenants that, in our view, favor the lender over existing capital market bondholders, and increase the potential for triggering the financing’s remedies.

Moody’s issued a report highlighting the shrinkage of the variable rate demand obligation (VRDO) side off the muni market. Moody’s says issuers are often replacing VRDOs with direct loans from banks:

Outstanding balances in the municipal VRDB market declined for the fifth consecutive year in 2013 as issuers sought the certainty of long-term fixed interest rates and banks offered low cost direct loans and purchases. Outstanding VRDBs declined by $35 billion in 2013, which is similar to the contraction in 2012 but less than half of the $79 billion decline in 2011.

The Sifma report has a great table of which banks are providing liquidity for VRDO issuers. Note the top four liquidity providers are also the nation’s largest commercial banks. I believe that long-term loans (fixed or floating) to municipal entities are high on the preferred lender list for these banks:

Muniland may not be shrinking so much as changing shape. Stay tuned.

Correction: Standard & Poor’s estimates that direct bank loans to muniland may account for as much as 20 percent of new municipal borrowing. A previous version of this piece did not specify “new.”

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