Municipalities sold the second-heaviest slate of debt in the history of public finance in 2009, boosted by federal legislation that tapped into a reservoir of demand for state and local government credit in other markets.
Just a year after financial crisis cast a cautionary pall over the market, municipalities closed out 2009 having floated $409.13 billion in debt, according to Thomson Reuters.
That represented an increase of 5% in volume over 2008. It was shy of the all-time record set in 2007 by about $20 billion.
A number of factors likely contributed to the expansion. After the economy did not collapse, investors grew more comfortable owning bonds with some illiquidity or risk of default.
The Federal Reserve’s campaign to drag short-term interest rates to the floor brought yields on bank deposits and money market funds practically to zero, coaxing money into higher-yielding alternatives such as bonds. The specter of a bump in the top federal tax rate enhanced the appeal of tax-free municipal bonds.
By far, though, the biggest factor boosting issuance this year has been the Build America Bonds program.
Enacted through the American Recovery and Reinvestment Act in February, the BAB program authorized municipalities to forego the traditional tax exemption on their debt and instead sell taxable debt and receive a federal subsidy equal to 35% of the interest costs.
The BAB experiment transformed municipal finance.
Municipal bonds have customarily been the domain of rich people looking to shield their money from taxes, along with a hodgepodge of profitable property insurers, commercial banks, and broker-dealers.
The tax exemption on state and local government debt forced most of the world out of the muni market. Foreign investors, pension funds, and investors in lower tax brackets had no reason to bid for bonds with tax-exempt yields.
While municipalities have sold taxable debt since 1985, it has constituted a small percentage of the market.
The BAB program enabled municipalities to issue big batches of taxable debt and access what turned out to be vast untapped demand.
Municipalities sold $84.47 billion in taxable debt in 2009, or 20.7% of total issuance. The highest taxable share of the municipal market prior to 2009 was 10.7% in 2003.
Issuers sold more than $64 billion of BABs since the first sale in late March.
While it is difficult to track who exactly is buying the new debt, foreign investors acquired $13.5 billion in municipal bonds in the second and third quarter, according to the Fed.
“The subsidized program created an incentive for issuers to borrow and to increase the size of their offerings,” said Richard Ciccarone, head of research at McDonnell Investment Management.
The BAB program did more than just expand issuance. It likely siphoned some of the bonds that would have been issued as tax-exempt debt into the taxable market. Sales of tax-exempt bonds shrank 5.3% in 2009.
Ciccarone pointed out it probably would have fallen even more if not for a surge in refinancings late in the year. The squeeze on supply of tax-exempt bonds helped tilt the supply-demand balance and push tax-exempts to record prices this year.
“The overall effect, as more and more of these taxable munis were issued, was to reduce the supply of tax-free munis,” Sheila Amoroso and Rafael Costas, co-directors of the municipal bond department at Franklin Templeton Investments, wrote in a year in review report. “Lower supply, all other things being equal, usually will result in higher prices, and we saw that at work in 2009.”
Investor demand was also fueled by the paltry returns on money market funds, they said. The average tax-free money market fund has yielded less than 0.1% for much of last year, according to iMoneyNet.
Bored with earning so little by playing it safe, investors pulled $92.3 billion from their tax-free money market funds in 2009, according to the Investment Company Institute.
Much of the money likely went to municipal bond mutual funds. Earlier this year, many muni mutual funds offered yields of more than 5%, they said.
“Once this realization spread among investors, demand for municipal bonds took off, reaching record levels throughout the year and providing much of the force for the strong returns we saw in 2009,” Amoroso and Costas said.
Investors entrusted $78.6 billion to municipal bond mutual funds in 2009, according to Lipper FMI.
Last year also saw issuance of variable-rate debt fall off a cliff. Variable-rate debt notes are bonds whose interest rates reset regularly. They typically require a credit guarantee from a bank in order to be marketable to money funds.
After the credit crisis devastated many banks’ balance sheets, letters of credit became more expensive and difficult to obtain. As a result, issuance of variable-rate debt sank 72.2% in 2009, to $32.3 billion.
Another “new normal” in municipal bonds was the volume of debt that came to market wrapped in insurance. According to Thomson Reuters, 8.6% of munis in 2009 were insured. That was the lowest penetration rate since Thomson started keeping track in 1982.
The financial crisis eroded many bond insurers’ capital cushions, forcing many of them out of the business. Only two companies, both run by Assured Guaranty Ltd., are writing new business.
