2.5 million muni bond investors unaffected by proposed tax changes
In his budget for fiscal year 2013, President Obama has resurfaced his proposal from last September to reduce the tax exemption for the wealthiest municipal bond investors. This tax reform proposal is unlikely to pass this year, but a battle is already raging in the media about what damage the change could do. Dire predictions of much higher yields for municipal bond issuers are being thrown around with little or no verification.
Even if this proposal did pass this year, muniland would not be disrupted. In fact I think it could democratize the municipal bond market in a big way. There are more than 2.5 million investors who own municipal bonds and would be unaffected by the proposal. It’s true that yields could rise a bit as the wealthiest investors exit the market, but this would just make muniland more attractive for the less affluent, since they would still be able to utilize their tax exemption. Rich investors would lose, but middle- and low-income municipal bond investors would gain.
Here are the specifics of the proposal from Market News International:
The administration is proposing to “reduce the value of itemized deductions and other tax preferences to 28% for families with incomes over $250,000.”
“Currently, a millionaire who contributes to charity or deducts a dollar of mortgage interest, enjoys a deduction that is more than twice as generous as that for a middle-class family,” the FY 2013 budget proposal reads.
“The proposal would limit the tax rate at which high-income taxpayers can reduce their tax liability to a maximum of 28%, affecting only married taxpayers filing a joint return with income over $250,000 (at 2009 levels) and single taxpayers with income over $200,000,” it continued.
Critics include the securities dealer trade group, SIFMA, whose representative, Michael Decker, was quoted by MNI:
“They [municipal issuers] will still continue to issue some bonds,” Decker said, “it will be more expensive, so they’ll have to issue less” since their debt capacity is limited, ultimately reducing supply in the muni market.
Like all of fixed income, there is massive demand for municipal bond issues, and offerings are oversubscribed by multiples of the offering amount. So the predictions that the yield for new municipal offerings will skyrocket defy logic. If 920,000 households that earn more than $250,000 per year and own municipal bonds receive less of a tax advantage, there are still 2,500,000 households that won’t be affected by the tax change. Those 2.5 million households at the bottom actually own more muni bonds than the top 920,000 households. And of course everyone forgets all the institutional demand that is wholly unaffected by this tax proposal.
What happens to muniland in 2012?
It looks like smooth sailing for the municipal bond market in 2012, according to three senior market participants who exchanged views at the Fitch Ratings 2012 Municipal Credit Forum. Continued strong demand for municipal bonds, ongoing low bond issuance, favorable Federal Reserve rate policy and major banks upping their direct loans to municipal entities will make 2012 another strong year.
Estimates of how many new municipal bonds will be issued in 2012 ranged from $300 billion to $350 billion. George Friedlander, a municipal strategist at Citigroup, dug a little deeper than the gross numbers and discussed the maturity profile of the municipal debt market. He talked about “bond years outstanding,” which is a new concept to me. Friedlander explained that with the massive amount of bond refundings that are happening in this low-interest-rate environment, the overall maturity of bonds outstanding is contracting. Or, to put it another way, as municipal bond issuers call long maturity bonds, they are replacing them with shorter duration bonds at lower interest rates. This shrinks the amount of bonds available in the 15-30-year range. It could help explain the new lows that the Thomson Reuters MMD AAA scale keeps hitting for longer maturity bonds. Friedlander had estimated that there was $90 billion more in bond refundings in 2011 than new issuance.
Given that refundings took up a big portion of 2011 bond issuance, Friedlander projected that there was $170 billion of “new money” that flowed into muniland last year. Much of the cash invested in the muni space was “old” money that investors had from their refunded bonds. This would help explain the meteoric performance of muniland in 2011, and it’s likely to have big implications for 2012.
On the demand side Sean Carney, a vice-president and municipal strategist at BlackRock, said that it had been incredibly strong and broad-based, especially when Treasury-muni ratios were above 100 percent, a widely used industry ratio for comparing return on federal and municipal debt. He also said that retail investors were getting comfortable buying longer-maturity and lower-rated bonds.
Thomas Doe, founder and chief executive of Municipal Market Advisors, said that many community banks had entered the municipal bond market as buyers. He said that over 5,000 community banks now own muni bonds, which was more profitable for them than making loans. Doe also discussed the activity of large banks making direct loans to states and other municipal entities and suggested that about one short-term loan a week was being made. He said that bank loans have the potential to become a permanent part of the municipal market but disclosure and loan covenants remained an issue. BlackRock’s Carney said that essentially all banks loans were being done by three major banks. Citi’s Friedlander said that the capital requirements of Basel III and a higher Fed funds rate could slow big bank direct lending. Currently big banks are capturing the arbitrage between their near-costless short-term borrowing and the higher rate they charge municipal entities to borrow funds.
BlackRock’s Carney said that they had been closely watching the proportion of interdealer trades to customer buys and sells. January had an unusually high level of trades between dealers, which reduces yields on bonds as dealers bid up the securities. Carney said that on average interdealer trades run about 14 percent of monthly trades, but January saw 24 percent of total trades done between dealers. BlackRock prefers fewer trades between dealers because dealers run up the price of bonds and they, rather than market participants, capture the profits.
All seems well in muniland. I met many interesting people at the event, and I’ll be writing up some of their views on differect sectors of the municipal market.
Muniland’s public officials are clueless, not corrupt
Matt Taibbi’s latest piece for Rolling Stone, “How Banks Cheat Taxpayers,” blasts a common municipal bond market practice in which a state or municipality selects an underwriter for an offering without soliciting competitive bids for the project. These are called “negotiated bond offerings” in muniland parlance, and Taibbi likens them to a legalized form of bribery:
By “negotiated underwriting,” what Bloomberg means is, “local governments just hand the bid over to the bank that tosses enough combined hard and soft money at the right politicians.”
I really hope that Taibbi’s is making a hyperbolic statement to draw attention to his main premise that new bond offerings should done on a competitive basis, with which I agree entirely. But he implies that all state and local politicians are standing around with their hands out and are actively being bribed by Wall Street banks. If our country is that corrupt, we are in for a lot of trouble.
In contrast to Taibbi’s view I think most public officials are overwhelmed by the complexity of the municipal bond markets, which are hard to understand, and rely on a “trusted” investment banker to guide them through the minefields. A great report from Claire McCaskill, who served as the Missouri State Auditor in 2005 and now represents the state in the U.S. Senate, contained the following:
Some issuers [local governments] used questionable reasons in choosing negotiated sales. In addition, officials contacted believed they achieved low interest rates on negotiated sales because underwriters offered rates below the national bond index. However, due to Missouri’s high credit rating, the majority of general obligation bonds issued in the state achieve rates below the national index.
The Missouri report says very politely that public officials are clueless. We’ve heard plenty of stories over the last few years of public officials being misled about the benefits of doing certain types of transactions. Wall Street can be very good at disguising the underlying structure of deals as opposed to their outward appearance.
There are scads of academic studies conducted over the last 40 years showing that bidding out bond offerings saves money. Several of those peg the savings at 20 basis points, or 0.20 percent of the cost of the bond offering. Using Bloomberg’s estimate that 80 percent of the market is done via negogiated deals, I would guess that state and local governments paid approximately $600 million in additional fees this year. Doing some very rough calculations, I’d say they paid securities firms $2.6 billion overall for underwriting services this year. And, of course, securities dealers make more by trading these bonds and managing them for client accounts.
Munis are the star performer of 2011
Bloomberg had a great piece that rounds up the factors that made municipal bonds the best performing financial asset of the past year. The story is framed as a knock on Meredith Whitney for her scare call a year ago:
This was supposed to be the year the $3.7 trillion state and local debt market would be rocked by an exploding pension time bomb and “hundreds of billions of dollars” of defaults, according to analyst Meredith Whitney.
Whitney’s Armageddon never came. Instead, munis became the star performers of 2011.
An investor who bought $10,000 of munis the day after Whitney’s Dec. 19 prediction on CBS’s “60 Minutes” television program would have made about $1,050, based on the 10.5 percent gain in the Merrill Lynch Municipal Master Index, which calculates price changes and interest income. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The muni return is better still because interest income is tax-exempt.
[...]
When returns are adjusted for price volatility, municipal bonds returned about three times more than corporate bonds and twice as much as Treasuries, according to Bank of America Merrill Lynch and Bloomberg data.
Found: $840 billion in municipal bonds
The Federal Reserve has quietly admitted they had undercounted about $840 billion of municipal bonds. Bloomberg reports on this new pile of assets:
The U.S. municipal-bond market is 28 percent larger than reported in June, according to a quarterly Federal Reserve release, which used new data showing individuals own more state and local-government debt.
[...]
“The estimate of household holdings of municipal securities and loans is revised up by about $840 billion, on average, from 2004 forward,” according to the Fed’s Flow of Funds Accounts report for the third quarter.
The Federal Reserve may not have intended to bury the news, but I couldn’t find an official press release acknowledging the adjustment to their data. The massive adjustment only appeared as text in the quarterly flow of funds release.
A drought of municipal bond issuance
All year long, muniland has been dragging its feet on issuing bonds. Budgets have been much too constrained to take advantage of historically low interest rates. At the end of the third quarter of 2011 issuance was 39 percent lower than 2010, according to Thomson Reuters SDC data. Nine-month issuance for 2011 was $160 billion versus $262 billion for the same period last year.
It’s a veritable drought.
What do muniland insiders think?
When the mainstream press pays attention to muniland, often it’s the most colorful and misinformed voices — think Meredith Whitney – that dominate coverage. So it was great to get some interesting data today on how municipal insiders view the market from the muni team at RBC Capital Markets. They did a survey of 116 municipal market professionals at the recent Bond Buyer’s California Public Finance Conference. Respondents included officials from federal, local and state governments; bankers; and other municipal finance professionals in attendance.
The key findings, shown in the chart above, are that industry participants worry most about the low level of bond issuance, headline risk and federal budget issues. Headline risk and federal budget problems are out of the control of everyone in the municipal space. But low issuance is a puzzler. Certainly these professionals have had their trade reduced as fewer bond issues come to market and as municipalities face harsher credit constraints than they are used to.
Another terrifying data point reported by RBC is the length of time respondents thought that it would take for state and local government revenues to return to pre-crisis levels.
The majority of survey responders think it will take four or more years before municipal revenues return to 2007 levels. We are looking at very hard times for muniland given that demands on state and local governments are likely to increase as more people seek Medicaid coverage and other support programs. Given this outlook it’s easy to predict that municipal bond issuance will remain very flat. State and local governments don’t have the fiscal space to easily take on more debt.
It’s hard times ahead but industry participants don’t seem overwhelmed by conditions. Chris Mauro, who heads the RBC municipal research team, said:
The interesting take-away from the recent California Public Finance Conference was that the percentage of respondents who feel that municipal defaults will be less in 2011 than 2010 has been going up while at the same time, the percent of respondents who believe that it will take four years or more for state revenues to return to pre-recession levels has also been increasing.
This reflects the growing confidence on the part of industry participants in the ability of state and local governments to manage through the current difficult fiscal environment but while at the same time, acknowledging that US economic weakness will limit the organic growth in state tax revenues.
The Christie discount
The Christie discount
The media is reporting that New Jersey Governor Chris Christie will announce that he is not running for the Republican presidential nomination this afternoon. That’s probably wise given that the credit markets’ opinion of New Jersey would undercut any claim candidate Christie could make to being a responsible budget manager.
If you look at the Markit municipal credit default swap chart above you can see that credit markets think that the financial condition of New Jersey is pretty bad. It ranks only behind California and Illinois as a poor credit risk. It would be very hard for Governor Christie to tell the story of his fiscal successes in his state given the data. To be a credible candidate for the presidency he needs to develop real improvement for his state and reverse the Christie discount.
Here is the real muniland story
From the blog Credit Writedowns:
US states and local governments cut their debt by 3.2% in Q2 and 4.2% in Q1. This year looks to be the first year since 1996 that local governments in the US reduced their indebtedness.
The calmest seas you will ever see
Low issuance, low defaults and low rates
For issuers, conditions are just about perfect in muniland now. Many have defered or withdrawn planned bond offerings, leading to greatly reduced supply for the year. Bloomberg estimates that 3rd quarter total issuance will be about $67 billion. This follows the $117 billion in muni securities issued in the first half of the year (data from SIFMA, Excel file link).
Defaults have also been puttering along at very, very low rates. This is due to some creative workout solutions, like Jefferson County’s negotiations with creditors, and many instances of postponement of problems, like Collingswood, NJ. I’ve seen estimates for total defaults for the year ranging from $1.8 billion (this number included unrated bonds) to $1.1 billion. Bloomberg says:
Municipal defaults have dropped this year to about $1.1 billion, a quarter of last year’s total, according to Bank of America Merrill Lynch. Local general- obligation bonds have accounted for only 1 percent of the 2011 failures [balance is revenue or conduit bonds].
The biggest benefit for state and local governments issuing debt is low rates. Low interest rates allow an issuer to bring bonds to market and pay a lower rate for the term of the bond — up to thirty years. Conversely this is bad for municipal bond investors who would like to receive higher rates for loaning money to state and local governments. One reason for low rates is that municipal interest rates tend to track U.S. Treasury rates, and those have tumbled with the European debt crisis. Secondly, there has been so little supply of new issuance that strong demand has driven rates down. Strong demand happens, in part, because yields on municipal bonds are still higher than yields on bank certificate of deposits or cash. Bloomberg one more time:
Yields on top-rated 10-year municipals were 2.02 percent yesterday after falling to 2 percent on Sept. 23, the lowest level since 2009, when Bloomberg records for the debt begins.
Part-time employment up in muniland
Incredible shrinking workforces
I’ve read in a few places that state and local governments were reducing the number of full-time employees and hiring more part-time workers. There is a story in the Dayton Daily News that nicely details the trend:
The data show that both the state and local Ohio governments attempted to get the work done by hiring more part-time employees. While local governments shed a little more than 11,000 full-time employees, they added almost 6,000 part-timers, a 4.6 percent increase. The state, meanwhile chopped close to 1,400 full-time workers and added 386 part-timers, a half-percent increase, according to Census data.
Ohio’s government job-shedding put it in the top third of the 50 states, although margins of error from the Census survey data make exact rankings impossible.
“This has been going on for years,” said Stanley Earley, Dayton deputy city manager.
In Dayton, the number of general fund employees, which includes police officers and firefighters, has shrunk from 1,898 people in 2001 to 1,313 people in March 2010, Earley said.
From March 2009 to March 2010 — the period covered by the recent Census survey — general fund employees shrunk from 1,436 to 1,313, he said.
“And we’re continuing to go down,” Earley said.
>> U.S. census data for state government employment
>> U.S. census data for local government employment
Rush to issue municipal bonds as rates go lower
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Resident Muniland expert
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The part of the President’s proposal that many, including myself, find offensive, is that is would retroactively change a fundamental term of bonds that were issued and sold prior to the enactment of the legislation. Investors chose muni bonds, in lieu of corporates of similar quality offering higher stated interest rates, because the promised tax exemption made them a marginally more attractive alternative. To change the rules after those bonds were marketed and sold under a promise of tax exemption, is extremely unfair to those investors who relied on the promised tax exemption in making their investment. I would not object to changes to the tax exemption for munis issued after the effective date of new legislation (although I do think it is misguided tax policy, motivated more by populist political considerations than economic policy), but changing the key terms of government securities after they have already been issued and sold is punative, unfair, and terrible public policy.