Finance

Analyst: City Bonds Still a Good Investment Despite Slow Market

A meager growth environment could have issuers tapering their borrowing, but local governments are still expected to be a stable investment.
by | November 25, 2013
 

A meager growth environment could have issuers tapering their borrowing but local governments are still expected to be a stable investment, a new analyst report says.

Forecasts for the next few years show Gross Domestic Product inching along at as little as half the historical rate. Various analyses, including from the Federal Reserve, project GDP growth in the 2 to 2.5 percent range – historically, growth as averaged as high as 4 percent annually. The stalling could have a negative impact on municipalities’ willingness to borrow, said analyst Tom Kozlik in his Municipal Bond Market Monthly report.

“Less growth gives issuers one more reason to have to temper spending habits,” Kozlik, an analyst at Janney Montgomery Scott wrote. “Consequences will likely result in credit deterioration and potential rating downgrades.”

But he says that doesn’t mean the municipal market is a shaky investment in 2014. Far from it, in fact. But investors should be wary of any municipality that has not had consistent credit ratings or has not improved underlying credit factors in recent years. Extremely distressed cities will remain the exception, said Kozlik, who is recommending municipal bond investors stick to high-quality general obligation and revenue bond issuers.

“High quality issuers are those who have been dealing with the new economic environment with their financial eyes open and those who plan and budget on a conservative basis,” he said. “We do not like and do not recommend investors consider municipal credits with highly speculative characteristics or where the level of political uncertainty is high.”

Still, investors should put credit ratings in their own context. As agencies have changed their ratings criteria in recent years, it has led to seemingly conflicting trends with Moody's Investors Service issuing more credit downgrades while Standard & Poor's has issued more upgrades. At the same time, investors have become more savvy -- many do their own analysis and don’t rely solely on a credit rating to determine whether a bond is investment grade in their view.

Political headwinds in Washington, D.C. could improve or worsen the picture in 2014. Looming ahead are two key deadlines: the current Continuing Resolution expires on Jan. 15 and Congress must approve a new spending plan or face another government shutdown. That means lawmakers must decide whether to keep spending caps in place that would lower federal spending for the remainder of the fiscal year (which started Oct. 1). Then, in mid-February, the Treasury is projected to hit its borrowing ceiling, potentially kicking off another debt limit showdown that could threaten the credit quality and borrowing ability of the federal government. If the debt ceiling is not increased, all spending would be eligible for cuts in order to avoid a federal default on payments and states and localities would likely suffer greatly from those cuts.

Austerity measures at the federal level have already cut into the progress state and local governments have made since the recession. Just as revenues at the lower levels began improving, fiscal policy in Washington tightened up, cutting as much as 1.8 percentage points out of the nation’s growth in 2013, according to an analysis in The Economist.

The Federal Reserve’s new leadership could also rattle the municipal market: incoming Chair Janet Yellen, who takes over from Ben Bernanke in February, is expected to start slowing down the Fed’s practice of quantitative easing (buying municipal bonds with newly printed money). When Bernanke hinted at doing that during the summer of 2013, it prompted a major sell-off in the market and spiked interest rates.

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