Municipal Bond Worries Grow as Prices Drop, Interest Rates Rise

Municipal Bond Worries Grow as Prices Drop, Interest Rates Rise
February 21, 2011

As states and municipalities look to get their financial houses in order, an increasing number could see downgrades of their bonds this year, according to a recent report from credit-rating agency Standard & Poor's.

The $2.9 trillion municipal bond market has been thrown into tumult in recent months, in part because of growing fears some states and local governments will default on their debt. Investors have pulled record amounts out of municipal bond mutual funds, and the yields on muni bonds, which move inversely to price, have hit their highest levels since the depths of the financial crisis in 2008.

A downgrade of a government borrower would likely put downward pressure on the price of its bonds, resulting in higher borrowing costs and potential losses for investors.

‘Costs Taxpayer More’
“When the entity eventually tries to raise money in a future bond offering, they will have to offer more interest to get their offering done. This, in turn, just costs the taxpayer more money and makes the finances of the entity even worse,” said John Olson, financial consultant with LPL Financial in Auburn, Massachusetts.

 “If the rating is moved deep enough into a ‘junk bond’ status, maybe no one wants to buy a bond from them at any rate that makes sense for the entity,” he added. “Then, perhaps, some projects don’t get done. This is why the Build America Bonds (BABs) were important, because the federal government said they would pay 35 percent of the municipal bond interest costs, making the payments more likely to be made and hence more secure.”

Build America Bonds were created by Congress in 2009 as part of the economic stimulus package. They expired on Dec. 31, 2010, after about $181 billion of the bonds had been issued. Local governments used the bonds to borrow money for projects ranging from new schools to sewer, water, and highway projects.

House Transportation and Infrastructure Chairman John Mica (R-FL) has said he would like to renew the program to boost transportation spending, but with a lower federal subsidy.

‘Groundwork for Defaults’
“The groundwork is certainly there for defaults to occur” on municipal bonds, said Robert Brownlie, co-chair of DLA Pipers’ securities litigation group. “Many municipalities are still suffering from lagging revenues, making it more difficult for them to meet their obligations. If things do not improve in the economy, you’re going to see increasing risk of default and bankruptcy.”

Any bankruptcies would result in a rash of litigation, with investors looking to recover what they can from municipalities and states, government agencies involved with municipal bonds (such as the water board if there is a default on a water bond), accounting firms, lawyers, and anyone else possibly associated with issuing the bonds, Brownlied added.

“They will be looking for the agencies with the deepest pockets,” he said.

Brownlie recommended cities and municipalities consider some sharp budget cutting to keep meeting obligations, provide essential services, and attempt to forestall bond rating decreases.

‘Hamper Borrowing for Years’
If bond ratings do decrease and interest rates rise, it could hinder the issuing agency for a long time, Brownlie says.

“It could hamper their ability to borrow to fund capital improvement projects for years to come,” he said.

They would find it difficult to borrow both because interest rates would be higher and because investors would tend to buy only bonds of a certain rating or higher. That means the lower the bond grade, the smaller the pool of potential investors, explained Deryck Palmer, partner and cochairman of the financial restructuring department of Cadwalader, Wickersham & Taft, LLP, New York.

“And once the downgrade is done,” he said, “it’s not over. The rating agency will come in again to make sure that you have taken corrective action.”

If the municipality, state, or other issuer has not taken such actions, another downgrade is possible, making the problem even worse, Palmer added.

Palmer recommends government entities faced with potential downgrades consider several different options for shoring up their finances. Although increasing taxes could theoretically increase revenues, it could also drive taxpayers out of the area, or the tax base could already be so small that an increase would do little to increase revenues.

Pension, Contract Problems
Many of the government entities faced with potential downgrades are saddled with collective bargaining agreements that are too lucrative for the revenue base, Palmer added. He recommends government agencies try to renegotiate those contracts to economically feasible levels.

“It’s much more commonsense to be proactive,” Palmer said.

Olson added: “They don't want to cut police, fire, and school budgets, so they have to look at nonessential areas. This is the reason pension plan expenses have come under fire. You can reduce pension expenses [by] doing two things. One, freeze benefits for older workers at current levels so they will be hurt the least. And two, reduce benefits for younger [under age 40] workers who they can help later when conditions improve.”

Phil Britt (spenterprises@wowway.com) writes from South Holland, Illinois.