Are some tax-exempt bond issuers incurring unnecessary costs and unexpected risks by over-relying on traditional fixed rate debt (TFRD)? In the five years prior to the 2008 Global Financial Crisis, 20 percent of tax-exempt issuance was short term or variable rate; since then, that share has decreased to and remained below seven percent. At the same time, the yield curve has steepened, increasing the cost of fixed rate over variable rate debt. The public sector's annual interest expense may be nearly $7 billion higher as a result.
Interest rates on TFRD are normally higher than rates on short-term or variable rate debt. Issuers are effectively paying investors to take away the interest rate, tax event, liquidity/credit and other risks. Compared to the lowest cost variable rate alternative, traditional fixed rate bonds now cost an additional $3.0-3.5 million per $100 million annually.
Are issuers paying a fair price to "outsource" these risks? We can calculate break evens to decide. For example, the Federal Funds rate would have to increase 3 1/2 percent over the next two years to overcome the initially lower cost of variable rate versus traditional fixed rate bonds over twenty years. This implies inflation well above the Federal Reserve's policy target for inflation of two percent.
Why is the price to transfer risk so high? Academics have been studying the so-called "Muni Puzzle" for years. This is the mystery of why tax-exempt rates in longer maturities are typically 0.5 to 1.5 percent higher than corporate rates, after accounting for income taxes. For example, a 20 year, AA tax-exempt general obligation rate was 3.04 percent recently. AA corporate yield was 4.23 percent, which results in after tax returns of 2.55 percent. This means that investors in munis are earning—and issuers are paying—an extra 0.49 percent. Academics have offered a number of explanations for this "deadweight cost": limited liquidity; market fragmentation; less robust disclosure; excess supply; risks of tax law changes and political risks. These factors increase the cost of fixed rate debt beyond what might be justified by the value of the risk transfer (or the ability to call the bonds).
Not only are fixed rate bonds expensive, but also they bring their own set of underappreciated risks. Foremost among these is commitment risk. Since traditional fixed rate bonds typically provide investors 10 years of call protection, it may be very expensive for the issuer to restructure its debt earlier. A need to restructure could result from any number of long-term risks including economic, competitive, political, regulatory, demographic, catastrophic, climate change, etc.
Furthermore, excessive fixed rate debt can also increase risk at the enterprise level when the issuer fails to match assets and liabilities. Issuers with insufficient variable rate debt relative to cash when the Federal Reserve cut short term rates to near zero in 2008 found to their chagrin interest income slashed while interest expense remained essentially fixed.
Many issuers may remain attracted to TFRD because fixed rates are historically low and short-term rates are forecast to rise. But, are forecasts reliable? Research has shown that a simple random walk model predicting on average no change in rates would have outperformed two-thirds of economists over the 1982-2002 period. We have also calculated that over the last six Fed tightening cycles, the SIFMA average over the following 10 years still averaged 4.6 percent below the tax-exempt fixed rate at the start of the cycle.
In brief, Traditional Fixed Rate Debt brings with it higher costs and perhaps unexpected risks. Issuers intending to avoid risk by employing TFRD are actually accepting a different set of risks. Moreover, an inefficient municipal market keeps the yield curve steep, keeping the costs of transferring risks to the capital markets high. To be sure, TFRD may well deserve its privileged place on the balance sheet of lower-rated issuers with limited financial flexibility. However, the high cost of fixed rate debt may not always be worth the perceived benefits for others. Many other issuers would benefit from a flexible yet risk-centric debt policy that supports alternatives to TFRD, where appropriate. Issuers with such policies are likely to be more resilient and better positioned to provide essential services regardless of what the future may bring.
