Conclusion: We firmly disagree with the relative “safety” of muni bonds, as current yields are at a disconnect with the underlying negative fundamentals that will begin to reveal themselves over the next 2-4 quarters.
Municipal bond yields increased 6bps wk/wk last week according to the latest Bond Buyer 20 General Obligation Bond Index. This marks the first weekly gain since a 1bps increase in the week ending July 15th. Much of the recent strength in Muni bonds has been attributed to the mixed-to-negative U.S. economic data out of late July and August, which caused some funds to chase yield via the relative “safety” of muni bonds. More recently, economic data (including jobless claims and consumer confidence) has been positive on the margin, which has stewarded investor confidence back into the equity market and away from muni bonds.
To be frank, we beg to differ regarding the perceived “safety” of these investments, as credit risks in municipalities and States across the country look to build as a result of slowing GDP growth, decelerating consumer spending and declining housing prices. Take Harrisburg, PA, for example, which intends to default on a $3.29 million bond payment this week. To help close the city’s $4.5 million budget gap this year, Mayor Linda Thompson drafted emergency measures including closing a fire station, increasing parking fees 67%, selling real estate tax liens and cutting $155k in personal expenses.
We don’t think the pending default or the aggressive austerity measures out of Harrisburg, PA will be a one-off event when it’s all said and done over the next 6-12 months. In the YTD, muni bond defaults have totaled only $1.7 billion, down from $6.9 billion in 2009. That number is likely to go up in 2011 based on the following negative fundamentals:
We’ve been vocal throughout the year highlighting the headwinds facing State and local governments over the next 12-24 months. States, which are facing a collective budget gap of roughly ~$140 billion in fiscal 2011, saw their 2Q revenue from sales, personal income and corporate income taxes trail original projections in all but four states. This is likely the reason that one-third of state spending in 2010 came from federal government American Recovery and Reinvestment Act of 2009 funds.
With the federal government under increasing pressure to reign in the deficit, where will the money come from in fiscal 2011? States have already spent 89% of their ARRA funding, so that leaves little federal reprieve to fill the budget gap. The latest National Association of State Budget Officers (NASBO) Fiscal Survey of State Budgets suggests states are baking in a 4% increase in tax collections in fiscal 2010. Keep in mind that housing, consumer spending, and personal incomes are the key drivers of roughly 87% of State and local government tax receipts (see image below). We think an increase of any magnitude is unlikely given the setup for employment, consumer spending and housing over the next year:
- Housing: As part of our Housing Headwinds Q3 Macro Theme based on Josh Steiner’s proprietary models, we expect housing prices to decline 15-30% over the next 18 months, absent major government intervention. What is really frightening to municipalities across the country, however, is that their appraisals operate on a 2-3 year lag with market prices. That means they are currently taxing properties roughly based on 2H07 market prices. Ouch.
- Employment: A key tenet of our American Austerity Q3 Macro Theme is that based on burgeoning federal deficits, U.S. public debt will grow to a level that structurally impedes growth going forward. Our 1.7% 2011 GDP growth estimate is 80bps below consensus and is subject to further downward revision. This will keep a floor under the unemployment rate, as pro-cyclical business investment stalls absent real growth opportunities.
- Consumer Spending: As of today, it appears the Bush tax cuts will be extended for all but those with incomes greater than $250k. A higher effective tax rate for the wealthy will have a substantial negative impact on consumer spending, as the top 5% of earners in America account for roughly 40% of consumer spending. Furthermore, the wealth effect associated with home ownership will erode on the margin should we prove right on housing prices in the coming quarters.
One ray of sunlight for municipal issuers has been investor appetite for Build America Bonds, of which interest payments are subsidized by the government (35%). These bonds have become the fastest-growing part of the $2.8 trillion municipal market, with total issuance of ~$130 billion since inception, according to Bloomberg data. The program is set to expire this year and is a near certainty that it will not be extended, based on current legislative gridlock and the likelihood that the GOP wins 7-8 seats in the Senate. It remains to be seen whether or not investor demand will naturally flow back to general obligation muni bonds once BABs are removed from the table. Even if it does, it is likely to be at higher yields than are currently in the market – given the negative fundamental outlook for many municipalities across the country and the prospect for much greater tax-exempt bond supply in 2011 (YTD issuance down ~20% Y/Y).
All told, we firmly disagree with the relative “safety” of muni bonds, as we feel current yields are out of touch with the underlying fundamentals, which will begin to reveal themselves over the next 2-4 quarters. The one positive we see is a marginal increase investor demand for tax exempt securities stemming from the Bush tax cuts likely not being extended to the wealthy. Even then, will that be enough to keep muni bond yields from backing up?
As always, time, data, and price will tell.