Turmoil and Trouble in the Muni Bond Market
A veteran issuer gives his perspective on the mounting woes over muni bonds.
It's been a stormy year for the municipal bond market. So stormy, in fact, that analysts called the lastest muni bond sell-off a "Lehman-like" event. Drawing parallels to the 2008 financial crisis is scary enough, but so have been this year's events: The sell-off in June was the biggest in more than 20 years -- it amounted to about 2.2 percent of the $680.7 billion managed by municipal bond mutual funds.
Add to that climbing interest rates and the Detroit bankruptcy -- which some fear is the first of many to come and others blame for today's skittish market -- and it's been a disheartening year for investors. There is even the ongoing drama of what the U.S. Congress will or will not do to the tax-exempt status of muni bonds.
How are these events affecting state and local issuers? What worries them most about the summer's events? And what, if anything, are they doing to cope? I put these questions to Ben Watkins, director of Florida's Division of Bond Finance and chair of the debt committee for the Government Finance Officers Association. Here's an edited version of our conversation.
How is the turmoil in the market effecting state and local issuers?
I would characterize what's happening in the market not so much as turmoil but as more of a grind to higher rates. This is all part of what they refer to on the investment side as the "Great Rotation." What is meant by that is that investors -- institutions and mom-and-pops -- generally come out of fixed-income assets and move to risk assets, such as stocks. Because of the extraordinary intervention by the Federal Reserve through quantitative easing and bond buying, interest rates have been artificially low for four years. Investors are now anticipating interest rates returning to more normal levels. The question is when. And that's what we've been seeing over the summer and are seeing now: Investors are beginning to anticipate that the end is nigh for the Federal Reserve taking extraordinary measures to keep interest rates low [and are pulling out].
Is this happening in all bond markets, not just the muni market?
Yes. You can see it in the Treasury market, which is the biggest and deepest market in the world. In May, the 10-year rate was 1.6 percent and now it's 2.8 percent; the 30-year Treasury was 2.8 percent and now it's 3.8 percent. The talk leading to this increase in rates had been about tapering, which is the code name for the Federal Reserve stepping away from their extraordinary intervention and tapering their bond purchases.
With low-interest rates coming to an end, what do higher rates mean for the ability of states to finance projects?
First, issuers were taking advantage of historically low-interest rates to refinance debt that's currently outstanding. That's been our primary focus and priority. Over the last four years, we [in Florida] have executed 54 [refinancing] transactions for a total of $8 billion, which is a big number for us. It's one-third of all our outstanding debt. But we refinanced it at lower rates and to give you a sense of the magnitude of these lower rates, our debt service savings on those transactions is $1.5 billion in interest costs.
The return to normalcy is what I call [the higher rates]. As rates return to more normal levels, it will be incrementally more expensive to finance infrastructure projects. But even when I look at rates today, they're still attractive. Rates on a 20-year, AAA-rated muni bond have gone from around 2.65 percent to almost 3.50 percent. When I look at 30 year bonds, they are at about 4.25 percent. So even with the increases we've experienced over the last 90 to 120 days, absolute interest rates by historic norms remain very attractive.
When you've seen this market through various cycles over the past four years, it has been in effect a seller's market -- a lot of capital was flowing into the muni space because of the relative safety and security of muni bonds and their attractiveness in yield relative to other investments. It drove interest rates to abnormally low levels. If you were financing a project with new money or refinancing, it was a great time to be selling. That's turned now. We are feeling the other side of that. It's very much a buyer's market. Investors can be much more selective. Money is flowing out of our space now -- out of fixed income in general.
Some pundits and experts on the market are saying that money is fleeing the market because of the specter of Detroit's bankruptcy. How do you react to that?
The negative headlines aren't helpful by any means, but I don't see that as being the trigger for this grind to higher rates. I don't see the same kind of market reaction as, for example, when Meredith Whitney made her call on hundreds of billions of dollars of muni bonds defaulting. I don't see that kind of knee jerk response by investors -- even though Puerto Rico and Detroit are in the headlines. The market has gotten smarter about these headline type of events. Investors may steer clear of those names and riskier sectors in our market, such as tobacco, health care and housing bonds.
I've been part of the muni bond market for 25 to 30 years so I have that perspective. The young people in my office, they think these transformative events are normal. They are not. They are very abnormal but it's all they know.
What about the "Great Unknown" -- the future of the tax exemption on muni bonds?
The No. 1 issue that blocks out all sunlight is the threat to the tax exemption. Congress can't get its act together and act like adults. We are living through extraordinary times. In addition to the threat to tax exemption, there's the sequester and balanced budget and debt limit. Those things might transform the muni market as we know it -- and not in a positive way.