The new decade for municipal issuance started with a bang.
Municipalities issued $31.8 billion of debt in January, a 37% increase from the prior year and a new record for the month, surpassing the $31.2 billion volume in 2007, according to Thomson Reuters.
While overall issuance surged, municipal debt has fragmented into separate markets. Taxable issuance is the culprit for the mammoth increase, while the traditional, tax-exempt market was actually down compared to January last year.
In February 2009, the Obama administration proposed and Congress enacted the American Recovery and Reinvestment Act, which established a new type of taxable muni bond called the Build America Bond. Under the BAB program issuers could forego the traditional tax-exemption on their debt and instead sell taxable bonds and receive a federal subsidy equal to 35% of the interest cost.
That created a tidal wave of muni issuance into the taxable market. Thanks to BABs, taxable bonds now command an unprecedented share of municipal borrowing.
In January, taxable bonds accounted for 34.8% of the total versus just 2.8% last year.
Until last year, taxable bonds contributed more than 10% of total municipal borrowing only once, when Illinois in 2003 floated a $10 billion taxable batch of debt to help fund its pension obligations.
Municipalities floated $6.9 billion of BABs last month, representing 21.6% of the market.
Conversely, the share of tax-exempt bonds has plummeted to 63.8%, from 95.3% one year ago. Until last year, the record low for the tax-exempt share of the market was 78.1%, in 1988.
This has contributed to what many traders and investors say is a worsening scarcity of tax-exempt bonds. The latest numbers offer little relief.
The volume of tax-exempt issuance fell 8.1% last month versus the prior January.
This number might not even tell the whole story. Bonds issued to refinance debt increased 73% in January. That means that municipalities may have sold as little as $14 billion of new tax-exempt bonds not replacing existing ones.
Many portfolio managers of traditional munis have said the availability of BABs to municipalities has pushed significant issuance from the tax-exempt market into the taxable market.
Thornburg Investment Management, for instance, in its report for the fourth quarter, mentioned “supply constrained by the emergence of Build America Bonds” as a key driver.
“Most of that represents displacement of tax-exempt supply, which is a predominant factor holding down tax-exempt yields,” the report said.
The S&P National AMT-Free Municipal Bond Index rallied more than 12% last year.
Richard Larkin, senior credit analyst at Herbert J Sims & Co., raised the point that BABs are enabling municipalities to access the market despite stressed credit. He noted some of the biggest BAB borrowers are states with oversized fiscal problems like Illinois, Pennsylvania, and California.
“This market appeals to non-traditional investors that may not be as attuned or worried about state fiscal stress,” he said. “The debt is being bought by a different class of investors such as taxable corporate funds, pension funds, and overseas buyers. I don’t know that they are looking at state budgetary problems in the same way that municipal investors might look at them. They might be a lot more casual.”
Another noteworthy trend is that insurance continues to command a much lower percentage of the market than it did most of last decade, when penetration routinely exceeded 50%.
Less than 7% of municipal debt sold in January was insured, compared with 15.1% in January 2009.
But contrary to predictions made in 2008 when bond insurers were rapidly exiting the market, local issuers “don’t seem to be hampered by the fact that there’s no viable bond insurance industry,” Larkin said.
State governments and agencies issued $16.2 billion of debt in January, a little less than half of all issuance, leaving the rest to counties and parishes, cities and towns, districts, and local authorities.
“The locals are issuing about half of the overall municipal debt and that’s pretty much the way it’s been since 2007,” Larkin said. “People were concerned that without bond insurance, small towns and cities weren’t going to be able to get market access, but it doesn’t look like they are being locked out of the market.”
By sector, only two areas were out of line with the trend seen over the last few months. General purpose bonds shot up 162% compared to last January and accounted for 40% of issuance in the month.
Tom Kozlik, municipal analyst at Janney Capital Markets, said the jump was big but not unpredicted.
“It was expected that general purpose issuance was going to be driving a lot of issuance not only in January but through the year,” he said. “In 2009 overall it was a little over 30%, so it’s a little higher this month and I’m not surprised by that.”
The other attention-grabber is housing, which didn’t see any issues come to market at all, compared with $330 million in January 2009.
Kozlik said that’s largely because of an $18 billion new-issue bond program created by the federal government last fall, which front-loaded deals a few months ago and drained supply for January.
“Housing issuers had to participate by the end of ’09, so that helps explain why housing was at zero,” he said.
New-money deals moved up 58% versus last year to $23.9 billion, while refundings jumped 73% to $6.2 billion.
Kozlik said one might assume that refundings would play a bigger role given that interest rates are so low, but refunding has two components, and low interest rates give savings on one end but not on the other.
“The problem right now is that escrow investment rates are also low and that is minimizing the amount of refundings that make economic sense,” he said.
January data also shows the average deal is getting bigger, perhaps indicating that investors in the taxable market prefer big, bullet-maturity deals. The average deal in January was $48.4 million, versus an average deal size in January 2009 of $36.2 million.