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Capital Markets

Munis: US states bounce back

Munibond fears abate; Volcker Rule may stem liquidity

Standard & Poor’s decision in February to revise its outlook on California’s A-minus rating to positive from stable signals a growing confidence in the US economy and an abatement of fears surrounding municipal bonds. Two years ago California’s credit default swap was trading in line with those of Portugal and Ireland and there were fears of a municipal market meltdown in the US. S&P credit analyst Gabriel Petek says in a statement that California is "poised for credit improvement – and potentially a higher rating – pending its ability to better align its cash performance and budget assumptions".

Last year the S&P municipal bond index returned 10.7%, making it one of the best-performing asset classes of the year. In January those returns continued to be strong, with the index returning 2.5%.

Yield attractions

Ashton Goodfield, head of municipal bond trading at DWS Investments, says: "Last year there was concern around a credit disaster and some money was leaving muni funds. But a lot of money is now coming in as fears have abated, and investors are looking for some yield as an alternative to the zero percent return on cash." Indeed, according to BlackRock’s Muni Market Overview in February, flows into municipal bond mutual funds were positive during each week of January, adding a total of $3.15 billion.

Robert Taylor, head of public finance at Barclays Capital, says that the credit picture for munis has improved. "Munis have done the difficult things that need doing," he says. "There is still a lot of noise around pensions, but most cities and states are dealing with that issue in one way or another. The pick-up in tax receipts makes the economic outlook feel a bit better."

At the end of January, the Rockefeller Institute of Government reported that state tax revenues were up 6.1% in the third quarter of 2011 compared with the same period in 2010 – the seventh straight quarterly increase. California, though, was one of only three states not to report an increase in tax revenues in the third quarter.

Tax take growth

Total state income tax and sales tax both grew, by 10.1% and 3.8%, respectively, and corporate income tax increased by 2.3%. Despite the positive figures from states, total tax revenues are still 1.2% lower than in the third quarter of 2008. At the end of fiscal year 2011, overall tax collections nationwide were still 3.5% below peak levels. Local government tax revenues in particular are still under pressure – mainly because they tend to lag behind states and depend more on property taxes. Local tax revenues declined 2% year on year.

It is hard to imagine a second year of double-digit returns for the muni market, and Goodfield is expecting lower returns with value in single-A and single-B credits. High volumes of issuance are expected in March. Puerto Rico, California and the City of New York are set to issue.

"Supply isn’t over the top," says Taylor. "In the low-rate environment we will see refundings. We expect around $300 billion to $325 billion in issuance this year, but that is lower than previous years." The high volume will cheapen muni bonds relative to treasuries and corporates, he adds, but the market remains attractive because of the credit improvements. Only if investors rebalance into equity markets is demand likely to drop.

Municipal returns in the last decade  
Barclays Capital Municipal Bond Index return 
Source: Barclays Capital 

New proposed regulation for greater disclosure around munibond sales is not expected to have a great impact on the muni market. At the end of January the Municipal Securities Rulemaking Board (MSRB) said it would propose a change to force underwriters to provide complete information to vendors. At present some blocks of bonds bought by investors are listed as NRO (not reoffered), and therefore do not disclose the price paid. That is likely to change. "It is positive for investors – price transparency always is – although it may make things more difficult for underwriters," says Goodfield. "But it won’t have much of an impact on the market."

The Volcker effect

More pressing is the impact of the Volcker Rule on municipal bonds. The rule, due to be finalized by July, that restricts banks from proprietary trading of securities has an exemption for general obligation bonds issued by municipalities but not revenue bonds. Goodfield says that unless the rule exempts all muni bonds there might be an impact on liquidity, particularly if there were a market dislocation or shock. "Already liquidity has been impacted by the absence of players such as Ambac and FGIC, " says Goodfield. She hopes that the Volcker Rule will be adjusted before July to exempt the muni market.

A final legislative change that might impact the muni market is president Obama’s push for reductions in tax breaks. In his 2013 fiscal budget Obama proposed once more that families with incomes of more than $250,000 should only be allowed to reduce their tax liabilities to 28% of income from 35%. It is feared that such a move would dampen the appetite of muni-bond buyers (who tend to be higher-net-worth individuals) because the bonds’ tax-exempt status would be less effective. Borrowing costs could be raised as issuers seek to make up for the tax costs lost to the buyer. One analyst, however, says such legislation is unlikely to get passed: "It has the potential to be an issue, but the government is very muni-friendly, and I can’t see this one getting through."

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