Buy Side

2Q Debt Shrinks as Prerefundings Mature

State and local governments’ outstanding debt shrank in the second quarter of 2010 for the first time in nearly 10 years as many of the facilities established during the prerefunding craze last decade matured.

Holders of Municipal Debt Chart

Municipal debt outstanding shrank by about $2 billion in the second quarter to $2.84 trillion, according to the Federal Reserve.

This was the first time outstanding state and local government debt shrank since the third quarter of 2000.

The complexion of muni ownership continues to change in keeping with the shift in the dynamics of municipal borrowing.

Foreigners’ holdings of municipal bonds leaped 15.4% to $83 billion as the Build America Bonds program made taxable state and local government debt attractive to investors who do not pay taxes in the U.S.

The biggest BAB deal of the second quarter was the Bay Area Toll Authority’s $1.5 billion revenue bond sale.

The bonds’ prospectus listed disclaimers to investors in 23 countries, on every continent except Africa and Antarctica.

The authority filed a separate memorandum for investors in Canada.

Analysts attributed the decline in debt outstanding mainly to a technical quirk stemming from a massive wave of refinancing that began about eight years ago.

Municipalities that want to refinance existing debt often sell “refunding” bonds and use the cash to buy Treasury bonds. The Treasury bonds are held in escrow, and municipalities use the cash flows from the Treasury debt to pay off their existing bonds until they are eligible to be called.

This “prerefunding” process was immensely popular last decade because of low interest rates and a flat yield curve.

Issuers sold nearly $580 billion of refunding bonds from 2002 to 2007, according to Thomson Reuters, compared with $356.9 billion the six years before that.

The proliferation of prerefunded bonds helped to inflate municipal debt outstanding, since a prerefunding essentially doubles the amount of debt outstanding for a single purpose by creating a refunding bond and a prerefunded bond for the same debt. As these prerefunded bonds mature and are not replaced, it shrinks the outstanding total.

“On the advanced refunding, you’re going from two bonds to one when the refunded bonds are called,” said George Friedlander, municipal strategist at Citigroup.

To estimate the shift in the amount of prerefunded municipal bonds outstanding, Matt Fabian, a managing director at Municipal Market Advisors, looks at the stock of outstanding Treasury bonds devoted to refunding municipal bonds, and applies an adjustment factor.

Based on this adjustment, the stock of prerefunded municipal bonds has shrunk by almost $130 billion since the middle of 2007, to $218 billion from $347 billion.

“The amount of the market made up by prerefunded bonds has been declining steadily for years now, and sharply,” Fabian said.

Prerefunded bonds outstanding, based on this measure, contracted by about $5 billion during the second quarter.

Fabian pointed out that the data shows that some of the owners of municipal bonds whose holdings fell the most in the quarter were the types most likely to hold the uber-safe prerefunded bonds: retail investors and nonfinancial corporations.

A second factor is also at play. Municipalities are not spending as much on infrastructure and new projects, leading to a drop in government borrowing.

Municipal governments borrowed $116.9 billion during the second quarter, according to Thomson Reuters, an 8.2% plunge from the second quarter of 2009.

State and local governments in the second quarter devoted an annualized sum of $340 billion to capital spending like purchases of equipment or infrastructure projects, according to the Bureau of Economic Analysis, down from an annualized rate of $355 billion this time last year.

“Issuers have demurred from selling more debt, in an effort to balance current budgets,” Fabian said.

This comports with an observation in Federal Reserve chairman Ben Bernanke’s monetary report to Congress in July, in which he noted municipal capital expenditures have fallen despite the stimulus from the federal government.

“State and local governments are still cutting spending in response to ongoing fiscal pressures,” the report stated. ­“Capital expenditures are not typically subject to balanced budget requirements; however, debt service payments on the bonds used to finance capital projects are generally made out of operating ­budgets (and thus must compete with Medicaid and other high-priority programs for scarce funding), which may be deterring governments from undertaking new ­infrastructure projects.”

With tax-free money market funds yielding 0.03%, according to iMoneyNet, cash continues to flee the industry and head for mutual funds.

Money funds’ holdings of municipal paper tumbled by $17.9 billion, while mutual funds’ holdings grew $13.9 billion in the quarter.

Property and casualty insurance companies, which own 13% of outstanding municipal bonds, pared a little more than $1 billion in holdings, to bring their total to $368.8 billion.

Insurers’ ownership of municipal bonds tends to trend with their profitability, since tax-free municipal bonds can be used to offset taxable income.

Property and casualty insurers reported $8.92 billion in pretax income in the second quarter, according to the Property Casualty Insurers Association of America, compared with $10.2 billion in the first quarter and $12.82 billion in the second quarter last year.

Friedlander, though, suspects the shedding of holdings is a simple matter of yields on municipal bonds not being attractive enough to tempt insurers’ investment divisions.

The 10-year triple-A municipal bond yields 2.4%, based on the Municipal Market Data scale.

Three years after their debut, municipal bond exchange-traded funds remain a minor but growing segment of the market, beefing up holdings by 11% to $7.3 billion. About 30 muni ETFs are now active, including a few BABs ETFs as the latest additions.

Closed-end funds have added less than $1 billion in holdings this year, despite returning 14.6% this year. The sector holds $82.7 billion in municipals.


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