Rise and Shine: ARRA Stimulates the Municipal Funding Market
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With the implementation of TARP (Troubled Asset Relief Program) and the passage of ARRA (American Recovery and Reinvestment Act of 2009), the federal government has pledged to rebuild the United States, both literally and figuratively. Some of the methods President Barack Obama’s administration will employ to revive the economy include monetary support for financial institutions, bringing liquidity back to the credit markets, and creating jobs by reconstructing aging infrastructure. Traditionally, the funding for these tremendously expensive fiscal policies has come either from increased taxes, or from municipalities borrowing money by issuing municipal bonds, or munis.
A MACRO LOOK AT MUNIS
A municipal bond is a debt security backed by a local government such as a municipality or a state to finance a capital expenditure for public consumption—a bridge, school, or highway, for example. In 1812, New York City issued the first municipal bond available to the public in order to build a canal (SIFMA 2007). Since that time, municipal bonds have helped local governments raise capital and have served many investors well.
Today, they’re as viable as ever. There are approximately 55,000 unique issuers of municipal bonds, including nonprofit organizations like hospitals and universities, as well as state and local governments (US House of Representatives 2008).
The current estimated market capitalization for the muni market is $2.6 trillion (Orol 2009). As a point of comparison, the market capitalization of all US equities is about $10 trillion (Wilshire Associates 2009). And the wealthy no longer dominate munis—former Securities and Exchange Commission chairman Arthur Levitt recently noted that one-third of all municipal bond investors are small investors (2009), and the Obama administration is opening the door for even more investors to participate.
Holders of munis are exempt from paying federal taxes on the interest received from these bonds. They may also be exempt from state and local taxes, particularly if the holder lives in the state in which the bond is issued. Those “triple tax-exempt” investments are extremely attractive to high-tax-bracket investors looking to reduce their taxable exposure.
Investors in these bonds are generally repaid in one of two ways. General obligation bonds are backed by the full taxing authority of the issuer. These are considered the safest municipal bonds and typically pay a lower interest rate than revenue bonds.
Revenue bonds are repaid from a predetermined future income stream from a specified project—a toll collected on a bridge or highway, for example. Since revenue bonds are a bit riskier than general obligation bonds, investors are rewarded with a slightly higher interest rate.
“Riskier” is a relative term, though. Historically, muni bonds have been considered a very safe investment. A 2007 study by Moody’s found that only one Moody’s-rated investment-grade muni bond defaulted between 1970 and 2006 (US House of Representatives 2008). Default rates for investment-grade municipal bonds rated by Moody’s and Standard & Poor’s are very low: 0.07% and 0.2%, respectively. That is far less than the 2.09% (Moody’s) and 4.14% (Standard & Poor’s) default rates for investment-grade corporate bond issuances (US House of Representatives 2008).
With many investors reeling from 30%–50% declines in their 401(k) and IRA accounts within the past year, with baby boomers nearing retirement, and with big earners facing an increased tax burden under the Obama administration, high-quality, relatively safe, tax-free investments are poised to attract increasing interest. As with any supply-and-demand relationship, a renewed interest in the bond market may stimulate investment in this sector.
MUNIS AND ARRA
Here’s a presidential quote that hits close to home: “We had a bad banking situation. Some of our bankers had shown themselves either incompetent or dishonest in their handling of the people’s funds. They had used the money entrusted to them in speculations and unwise loans. This was of course not true in the vast majority of our banks but it was true in enough of them to shock the people for a time into a sense of insecurity and to put them into a frame of mind where they did not differentiate, but seemed to assume that the acts of a comparative few had tainted them all. It was the Government’s job to straighten out this situation and do it as quickly as possible—and the job is being performed.” The president went on to say that “we have provided the machinery to restore our financial system; it is up to you to support and make it work. It is your problem no less than it is mine. Together we cannot fail.”
Those words were delivered by Roosevelt in one of his famous fireside chats during the Great Depression (1933). But, alarmingly, the rhetoric could just as easily have come from Obama as he gathers support for ARRA, aka “HR 1 (House Resolution 1),” aka “the Act.” (See US Congress 2009 for all references to the Act, unless otherwise noted.)
The Act passed the Senate and the House on February 13, 2009, and was signed into law on February 17. One of the most significant legislations in recent history, its statement of purposes runs as follows: to preserve and create jobs and promote economic recovery; to assist those most impacted by the recession; to provide investments needed to increase economic efficiency by spurring technological advances in science and health; to invest in transportation, environmental protection, and other infrastructure that will provide long-term economic benefits; and to stabilize state and local government budgets, in order to minimize and avoid counterproductive state and local tax increases and reductions in essential services.
In support of these goals, the Act attempts to stimulate investment in municipal bonds. For instance, during 2009 and 2010 only, the Act permits states to issue a new type of muni, the BAB (Build America Bond). Demand for BABs has already exceeded expectations, as evidenced by the issuance of more bonds than projected by entities such as the New Jersey Turnpike and the New York Metropolitan Transit Authority (Levisohn 2009).
Two types of BABs exist: tax-credit BABs and direct-payment BABs. The bondholder is taxed on the interest on tax-credit BABs, but receives a tax credit of 35%. The US Treasury Department explains: “If a state or local government were to issue Build America Bonds at a 10% taxable interest rate, the Treasury Department would make a payment directly to the government of 3.5% of that interest, and the government’s net borrowing cost would thus be only 6.5% on a bond that actually pays 10% interest” (2009). This credit (as opposed to traditional tax-exempt interest) will benefit those investors who fall below the highest tax brackets. The interest paid by issuers of tax-credit BABs is higher than the interest for a typical muni (taxable bonds generally provide a greater return than tax-free bonds). However, with the federal government’s assistance and subsidies, municipalities actually save money by financing projects via these bonds rather than via the traditional muni market.
The interest on direct-payment BABs is also taxable. These munis provide a federal subsidy (a direct cash “payment”) of up to 35% to the state and local governments that issue them, provided that 100% of the proceeds used are capital expenditures. The tax credit applies only for tax-exempt government bonds, not private-activity bonds. The intent is to make lending for capital projects cheaper in order to stimulate more projects, more investment, and more jobs. (See IRS Notice 2009-26  for additional guidance on BABs.)
Another new muni, the recovery zone economic development bond, offers an even larger tax subsidy, provided the bonds are issued for “qualified economic development purposes” prior to January 1, 2011 (IRS 2009). A recovery zone is an area designated by state and local governments as having significant poverty, unemployment, rate of home foreclosures, or general distress; or any area for which a designation as an empowerment zone or renewal community is in effect.
There is a total limit of $10 billion available for the issuance of recovery zone economic development bonds; that money will be allocated to states based on the proportion of their employment declines to the employment declines of all states, with each state entitled to at least 0.9% of the aggregate allocation. Within each state, the bonds will be further dispersed in proportion to employment declines. The federal government will provide issuers of recovery zone economic development bonds with an advance tax credit equal to 45% of the interest on the bonds. Private activities may not be financed with this program.
A similar allocation process is in place for recovery zone facility bonds, which have a $15 billion limit. Eligibility is limited to property that is within a recovery zone and that is acquired after the date on which the area in question is designated as a recovery zone. The property must be used by a qualified business (most types of businesses qualify) and must be eligible for depreciation.
Other new bonds ARRA has created include qualified school construction bonds (financing the construction, rehabilitation, or repair of public school facilities) and tribal economic development bonds (providing up to $2 billion in tax-exempt bonds, excluding use for gaming activities, and limited to activity on tribal lands). The definition of high-speed-rail exempt-facility bonds has been tweaked slightly to allow more projects to qualify. To encourage green investments, ARRA has expanded the allocations of energy conservation bonds and clean renewable energy bonds. The Act has also increased the allocation for qualified zone academy bonds (the proceeds are used for non-new construction expenditures for school facilities).
But the benefits of ARRA for the municipal marketplace aren’t limited to new bond issuance. The Act also aims to attract a new group of muni investors by revising some rules pertaining to the AMT (alternative minimum tax). Introduced in 1969 and amended many times, the AMT is a minimum tax levied on individuals and corporations with a tax liability deemed to be too small relative to income. The intent of the AMT is to eliminate loopholes for the wealthy by ensuring that, regardless of tax shelters, all individuals will always be subject to some taxation. Those obligated to pay the AMT are subject to “items of tax preference” as defined in the tax code, including interest on certain tax-exempt investments. By making that interest taxable, the AMT had effectually eliminated the benefit of munis for certain investors.
Now, though, the Act no longer considers the interest an item of tax preference for tax-exempt private-activity bonds issued in 2009 and 2010. Furthermore, for corporations, interest on tax-exempt bonds will not be included in adjusted gross income. There is also a provision for refunding certain private-activity bonds issued between 2004 and 2008.
MUNIS: THE PLUS AND MINUS
Moody’s has assessed the US local government sector for the first time ever, and has found it wanting: “This is the first time we have assigned an outlook to this extremely large and diverse sector. This negative outlook reflects the significant fiscal challenges local governments face as a result of the housing market collapse, dislocations in the financial markets, and a recession that is broader and deeper than any recent downturn” (2009).
Local governments’ challenges—“sharply falling property values, contracting consumer spending, job losses, and limited credit availability”—are bad news for the municipal bond marketplace. To make matters worse, Moody’s notes that, because property taxes comprise 72% of local governments’ tax revenues, the bursting of the housing bubble has had an even more profound effect on a local level than on a national scale. The downgrade has raised hackles on many muni investors, especially coupled with a possible long-term escalation of interest rates.
If the Moody’s downgrade and the crumbling economy weren’t enough to make muni investors nervous, yields on muni bonds have been steadily rising. Bond prices, of course, have an inverse relationship with their yields. As yields rise, prices decline. Current bondholders prefer yields to decline so that bond values increase. For prospective bondholders, rising yields make bonds more affordable. Investors in muni bond mutual funds are subject to these daily fluctuations in the market, as reflected in the closing prices.
According to the Bond Buyer 20-Year Municipal Bond Index (Federal Reserve 2009), which is based on an average of certain general obligation municipal bonds of varying quality with 20-year maturity, yields on municipal bonds rose nearly 30% (from 4.29% to 5.56%) from September 2005 to December 2008, signaling a possible long-term uptrend in muni yields. The December 2008 yield of 5.56% is the highest reading on record since October 2000 (5.59%). Except for a blip above 6% in January 2008, the monthly index has not reported returns this high since the mid-1990s. After the early 1990s, returns stopped hitting the 7% range, while double-digit returns disappeared in the early 1980s.
Bond Buyer 20-Year Municipal Bond Index, Monthly Yield and 10-Year Trailing Average, January 1963–May 2008. Bond Buyer Index: general obligation, 20 years to maturity, mixed quality, Thursday quotations.
Source: Federal Reserve, May 2009.
The chart above offers an interesting perspective. By calculating a simple 10-year trailing average of the monthly yield, both historical patterns and the long-term trend can be determined. On at least five occasions from the early 1960s to the mid-1980s, the monthly yield remains higher than the ten-year average, with the ten-year average acting as “support” (indicated by the dark blue arrows). The trend (highlighted by the early 1980s’ double-digit returns) generally slopes upward during this period, never falling significantly below the 10-year trailing average. On at least four occasions since the mid-1980s, the monthly yield remains lower than the ten-year average, with the ten-year average acting as “resistance” (indicated by the gold arrows). The trend generally slopes downward during this period, never crossing significantly above the 10-year trailing average.
Until now. Recently, the actual monthly yield made a significant “crossing” above its ten-year average, an event that has not happened since 1985 and that may signal a significant change in the muni market. (With the advantage of hindsight, it’s apparent that yields never returned to 1985 levels after the last notable crossing.) If yields do indeed rise, prices will fall, possibly triggering an entry point for new investors but causing pain for existing bondholders.
But this isn’t a typical market or typical year. Bond insurance, the safety net for municipal investors, has endured its own challenges. Ambac and MBIA both suffered recent downgrades. According to Bloomberg.com, bonds covered by bond insurance decreased from 60% in 2005 to 18% in 2008 (Mysak 2009). This has hurt smaller issuers, who generally need the insurance to receive favorable credit ratings.
Equally bleak is the fact that the auction-rate market, where investors used to safely park cash to earn rates slightly higher than the money market, has completely dried up. Fed Deputy Director David Wilcox recently admitted it has all but “disappeared” (Crittenden 2009). The lack of buyers has forced many companies left holding bonds at unattractive values to take large write-downs in assets. In fact, lawsuits are starting to emerge against banks that sold auction-rate bonds (Fox 2009).
So is this the end of the line for municipal bonds, despite their robust history of relatively safe, tax-advantaged financing since 1812? Hardly.
The muni market has rallied in 2009. As of May 2009, yields had declined to 4.56%, down 18% from the early December high of 5.56%. Warren Buffet doubled his municipal bond holdings from June 2008 to March 2009 (Crippen 2009). In mid-May 2009, the municipal bond market enjoyed nearly double the return of the corporate bond market (8.6% to 4.5%) for the year to date (Levine, May 18, 2009). And, as further proof of a strong muni environment, consider that, according to Merrill Lynch, munis returned over 11% during the period of more than six months that ended June 2009, compared to a 4.7% loss in Treasuries over the same time frame (Levine, June 11, 2009).
Clearly, both bullish and bearish cases can be made for this market. But ARRA indisputably did breathe some life into at least a short-term bull rally in municipal bonds, or, as the Municipal Advisor dubbed it, a BAB-induced rally (Municipal Market Advisors 2009). As far as long-term trends go, rising yields, potential interest rate hikes, and pending inflation may exert downward pressure on municipal bond pricing. Proceed with caution.
Crippen, Alex. June 9, 2009. “Warren Buffet Buys Big ‘Bargains’ in Muni Bonds.” CNBC.
Crittenden, Michael R. May 20, 2009. “US Municipal Debt Market Still Strained—Fed Official.” Dow Jones Newswires.
Federal Reserve [Board of Governors of the Federal Reserve System]. May 2009. “Bond Buyer GO 20-Bond Municipal Bond Index.”
Fox, Eric. May 20, 2009. “Auction Rate Securities Still Plague the Market (BBBY, JBLU, LSCC).” Investopedia.
IRS [Carla Young, Timothy Jones, Office of Associate Chief Counsel (Financial Institutions and Products)]. April 3, 2009. “Part III: Administrative, Procedural, and Miscellaneous; Build America Bonds and Direct Payment Subsidy Implementation; Notice 2009-26.”
Levine, Deborah. May 18, 2009. “Municipal Bond Returns Double Corporate Debt This Year.” MarketWatch.
———. June 11, 2009. “Muni Bonds Expected to Continue Hot Streak, Investors Say.” MarketWatch.
Levisohn, Ben. May 7, 2009. “Build America Bonds.” BusinessWeek.
Levitt Jr., Arthur. May 9, 2009. “Muni Bonds Need Better Oversight.” Wall Street Journal.
Moody’s Investors Service [Moody’s US Public Finance]. April 2009. “Moody’s Assigns Negative Outlook to US Local Government Sector.”
Municipal Market Advisors. May 2009. “Market Summary: Municipals Facing Challenges from Other Assets.” Municipal Advisor.
Mysak, Joe. May 18, 2009. “Cities Ask Treasury for $5 Billion to Fund Public Bond Insurer.” Bloomberg.com.
Orol, Ronald D. May 21, 2009. “SEC: More Authority over Municipal Bonds Needed.” MarketWatch.
Roosevelt, Franklin D. March 12, 1933. “On the Bank Crisis” [Fireside Chat]. Franklin D. Roosevelt Presidential Library and Museum.
SIFMA. February 13, 2007. “Securities Industry and Financial Markets Association; Statement Submitted for the Record; House Committee on Transportation and Infrastructure Subcommittee on Highways and Transit; Hearing on: Public–Private Partnerships: Financing and Protecting the Public Interest.”
US Congress. February 12, 2009. “American Recovery and Reinvestment Act of 2009.” US Government Printing Office.
US Department of the Treasury [Press Room]. April 3, 2009. “Build America Bonds and School Bonds: Investing in Our States, Investing in Our Workers, Investing in Our Kids.”
US House of Representatives. September 9, 2008. “Municipal Bond Fairness Act.” US Government Printing Office.
Wilshire Associates. 2009. “Wilshire Broad Market Indexes.”
–Howard Spieler is the compliance officer for NYCIDA (New York City Industrial Development Agency) and a senior vice president of the NYCEDC (New York City Economic Development Corporation). The views expressed herein are those of the author alone and do not reflect those of the NYCIDA, NYCEDC, or the City of New York
This article was originally published in the Summer 2009 issue of the Investment Professional.