MuniLand

Municipals are a small part of the American Jobs Act

President Obama held a ceremony on Monday in the Rose Garden, complete with a backdrop of teachers and law enforcement officers, to promote his American Jobs Act. The President has insisted that his proposal would be fully paid for by tax increases on the wealthy. What was less reported was that the $447 billion of proposed tax increases, Section 401 in the legislation (page 134), would not occur until 2013 and would stretch over 10 years. So under the President’s proposal there would need to be tax increases of approximately $47 billion a year from 2013 through 2023.

It’s been reported that Republicans are cool to the President’s proposal and it’s likely that they will object to paying for new stimulus programs with revenue generated in the next decade. In addition, the President’s proposal for $447 billion in tax increases will have to be added to the $1.5 trillion of savings that the Congressional super-committee will be looking for. So if the President’s proposal is embraced, the super-committee will need to find $2 trillion of savings from the federal budget over the next 10 years.

The bulk of the proposed tax increases in the President’s plan will come from adjustments in the deductions allowed for municipal interest and itemized deductions for individuals earning over $200,000 per year. This would account for about $400 billion of tax increases over ten years.

An additional $47 billion of taxes would come from levies on corporate jets, oil and gas companies, and hedge fund and private equity carried interest.

As the media began to report on these proposals, investors in municipal bonds took notice, worried that if adopted these reforms would be a first step to end the tax exemption for interest income on municipal bonds. What is not clear when you look at the specific language of the legislation and the statistics from the Internal Revenue Service is that this proposal would have a very big effect on muniland.

Obama proposals could shift municipal bond buyers

Obama would pay for jobs bill with 2013 muniland tax changes

The White House released draft legislation yesterday for the $447 billion American Jobs Act of 2011 which outlined proposed changes in the tax code to offset its major component — the extension of the payroll-tax reduction. The President’s proposal would raise income taxes on the wealthy by limiting income that can be excluded from taxation, mainly by limiting this exclusion for interest earned on municipal bonds.

This income tax increase for the more well-to-do would come into effect for taxable years beginning on or after Jan. 1, 2013. Generally, municipal bond ownership is concentrated in the higher tax brackets. From the Bond Buyer:

Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher, Fabian said.

Must infrastructure spending shrink along with muniland?

Paul Krugman at the New York Times has a good graph that shows a substantial withdrawal of government demand from the economy. He attributed this to the decline of federal government stimulus to state and local governments as the American Recovery and Reinvestment Act winds down. There is also another factor that is reducing government demand: state and local governments are issuing less debt, which in turn creates fewer building projects and construction jobs.

Municipal bond issuance is about $108 billion less this year than the same period in 2010. Several stories today highlight how states and cities continue to face fiscal challenges that cause them to lower the amount of municipal bonds that they issue for infrastructure projects.

Does reduced state and local infrastructure spending suggest a rationale for increased national infrastructure spending as hinted at by President Obama? Will his proposal be big enough to make up the shortfall of municipal spending on infrastructure? From Bloomberg:

Local governments’ tough choices between payrolls or bond payments?

Harrisburg walks the well worn path

The capitol city of Pennsylvania, Harrisburg, is functionally if not legally bankrupt. Yesterday the City council voted against the mayor’s rescue plan which would have brought them a small reprieve but would not have fixed their core financial issues. The city’s main problem is a grossly expensive incinerator project which has burdened the city with way too much debt. Their situation is similar to the sewer system woes of  Jefferson County, Alabama on about one tenth the scale. Like Jefferson County, anger about bondholders being prioritized ahead of the needs of citizens was on display at yesterday’s city council meeting. From Reuters:

“Wall Street gets paid and Main Street gets the shaft,” Councilman Brad Koplinski, who voted against the plan, said during the angry, packed council meeting.

At the root of Harrisburg’s troubles is a complicated financing scheme used to fund a state-of-the-art revamp of its trash-burning incinerator that left the city saddled with a $300 million debt.

California: the queen of borrowers

California is the queen of U.S. states given her size, wealth and desirability. Her economy is the eighth largest in the world and, as of 2008, the gross state product (GSP) was about $1.85 trillion, or approximately 13 percent of the country’s gross domestic product (GDP). It makes sense that she is the largest municipal bond issuer given her population, geographic size and infrastructure needs. California dominates muniland on many levels.

Although California has a large and powerful economy, she also has a history of more dynamic economic swings than the rest of the nation. I’m not sure where the volatility comes from but I thought the comparison between the U.S. unemployment rate to the rate of joblessness in California over several economic cycles was interesting. In 2010 California’s rate was 12.4% while the national rate was 9.6% (data provided by the California Department of Finance). There are substantial regional weaknesses in the Golden State.

The Treasurer of California, Bill Lockyer, keeps track of the state’s borrowing and provides the graph below showing that $71 billion of general obligation bonds have been issued. The state legislature has set a debt ceiling of $150 billion and it’s likely that the Treasurer will be coming to the municipal bond market to issue more bonds soon. In July he borrowed $5.4 billion through a bridge loan from Wall Street banks to tide the state through the turmoil of the U.S. Congress raising the federal debt ceiling. Market talk is that he will borrow approximately $11 billion in the fall to repay the short-term bridge loan and fund additional infrastructure projects. The Golden State issued $10.5bln of general obligation bonds during 2010.

The gusher of municipal bond information

The municipal bond market is often thought of as complex and murky. This is understandable; after all, there are over 50,000 issuers of bonds and a million plus specific municipal-bond issues. It’s staggering to imagine so many different securities.

A specific bond issue can be as small as the $995,000 offer that the city of Moose Lake, MN has coming to market this week, or as big as last week’s jumbo-sized $10 billion “State of Texas Tax and Revenue Anticipation Notes, Series 2011A”. (The Texas notes mature in one year and are paying 2.50 percent interest — they’re hot as griddle cakes.)

Municipal bonds also come in many different shapes because there is very little standardization of structure among municipal bonds. A straight bond generally has a fixed interest rate, or yield, and a set maturity date, or time of repayment. But many municipal bonds have floating interest rates; many others can be called or refinanced when interest rates go down. Regulatory agencies like the MSRB or the SEC don’t require that bonds have a certain structure or feature, only that the details are fully and accurately disclosed.

Where are muniland’s cross-over buyers?

It’s an odd moment in muniland. There is an irregularity in the pricing of municipal bonds. Generally muni bonds have a lower yield than U.S. Treasuries because munis give investors a tax advantage. Investors use them to shield their investment income since coupon payments on municipal bonds from their state of residence are generally triple-tax-free — that is, they are not taxed at the local, state or federal level.

In this Bloomberg video Timothy Pynchon, a portfolio manager at Pioneer Investment Management, talks about how 30-year muni bonds are trading at 105 percent of the value of the 30-year Treasury. These bonds would usually trade at less than 100 percent of Treasuries because of their tax advantages.  This is a very unusual situation and would usually attract so-called “cross-over” buyers from other parts of the bond market. In the video, Cumberland Advisors’ David Kotok suggests that since U.S. Treasuries are mispriced (too expensive with low yields as a result of a flight to quality) it’s having a carry-over effect for long-dated municipal bonds. Basically the long end of the municipal bond market has moved away from its normal pricing relationships and is cheap relative to Treasuries.

Further:

Bloomberg: Colorado Refunds Transport Debt as Yield at Lowest Since 1994: Muni Credit

Harrisburg, PA next?

Bankruptcy for Harrisburg finally?

The fiscal troubles plaguing Harrisburg, Pennsylvania have been well telegraphed in muniland. Reuters detailed the problems earlier this month:

Pennsylvania’s state capital, a city of 50,000 about 100 miles west of Philadelphia, has been flirting with bankruptcy as it struggles to pay off $300 million in debt incurred through a financing scheme used to fund a revamp of its trash-burning plant.

In July, the city council rejected a rescue plan put forward by a state-appointed advisor that called on the city to sell the incinerator, renegotiate labor deals, cut jobs, and sell or lease its parking garage.

Does a downgrade cost anything?

The debt of the United States was downgraded by Standard & Poor’s several weeks ago, but the price of U.S. Treasuries have skyrocketed since then. This confuses many people because a baseline relationship in the fixed-income markets is that lower-rated, less-creditworthy bonds will be relatively cheap and investors will demand higher interest rates to compensate for additional risk.

To see this bond market truism, it’s much more instructive to look at the downgrade of the debt of New Jersey. Fitch lowered the state’s credit rating Wednesday citing heavy debt and benefit obligations. This followed downgrades by Moody’s and S&P earlier in the year. Municipal bond and credit default swap markets didn’t like this third downgrade and did what you would expect them to do: they required more yield in the case of cash bonds and more payment in the case of credit default swaps.

The graph above charts muni CDS prices for New Jersey (data supplied by Markit). You can see the move up in CDS prices began in June when Governor Christie and the state legislature made the final run to their agreement on the fiscal 2011 budget, which began on July 1. The uncertainty and contentiousness of the process must have spooked investors and dealers.

New leadership for muniland’s regulator

New chair for muniland’s regulator

New leadership has been announced at the Municipal Securities Rulemaking Board, muniland’s primary regulator. Alan Polsky of Dougherty & Co., the incoming MSRB chairman, has spent much of his career working towards increased transparency in the muni secondary market where bonds trade after issuance. This is great news. From the Bond Buyer:

Alan D. Polsky, senior vice president of Minneapolis-based Dougherty & Co. LLC and former chair of the National Federation of Municipal Analysts, will be the next chairman of the Municipal Securities Rulemaking Board beginning Oct. 1, according to market sources.

Polsky spent a great deal of time trying to improve secondary market disclosure when he chaired the NFMA in 2001. During that year, the NFMA issued several “best practice” disclosure documents recommending how issuers, borrowers, and other market participants could improve disclosure in various sectors of the market. Polsky also was a member of the Muni Council, a group of about 20 muni market group representatives dedicated to improving secondary market disclosure. The group was responsible for the creation of the Central Post Office facility which temporarily served as a one-stop place for issuers to file their disclosure documents.

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