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Rollover Risk Less In Munis

OCT 14, 2010 6:14pm ET
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Most municipal analysts bristle at the claim that California will “become the next Greece.”

Among the important differences is that California prepares to repay debts with its own revenues; Greece assumes it can repay its debts by borrowing more.

A common risk in most financing markets is “rollover risk.” When a borrower has a debt maturity coming due, it often needs to borrow again to pay off the existing loan, or “roll it over.”

This presumes access to functioning capital markets where investors are willing to extend loans. One needn’t look too far back in time to see this is not always the case.

Borrowers unexpectedly facing the prospect of failing to roll over debt was a primary cause of the financial crisis of 2008 and the sovereign debt crisis of 2010.

Since municipal borrowers in the U.S. generally plan to pay off debt steadily over time from taxes and other organic revenues, rather than roll it over, this risk is far slighter in municipal investing than in most other markets.

Municipalities that sell bonds to raise money for a project commonly size the maturities of the bonds to achieve level debt service. This means the interest and principal payments will be roughly even each year until the final bond matures.

This follows a public finance economics concept known as “pay as you use,” which holds that taxpayers should pay for a project evenly over its life, rather than all at once at the beginning or the end.

This tendency means that municipalities usually have a predictable cost of repaying debt each year. They do not need to borrow money again to pay off the debts they already have.

“You don’t have rollover risk or market access issues, which you have with sovereign or corporate issues,” said Eric Friedland, group credit officer for public finance at Fitch Ratings. “When people ask us to compare California to Greece, one of the check marks for the municipal market is the fact that the conventional municipal issuance is 20-to-30-year amortized, that doesn’t expose the issuer to refinancing risk.”

An important disclaimer: municipalities in the U.S. are not completely immune to rollover risk.

Municipalities use bond anticipation notes, tax anticipation notes, commercial paper, and some other tools that rely on market access for bridging gaps between cash receipts and outlays.

Plus, municipalities have about $390 billion in variable-rate debt obligations, which are long-term debt structures supported by two- or three-year bank guarantees. The need to regularly renew these guarantees exposes governments to the risk that banks lose their appetite for guaranteeing municipal debt.

Friedland said some of the credits Fitch is most concerned about are weak issuers with shaky market access that will need to meet short-term liabilities. Generally, though, municipalities’ rollover risk is far slimmer than it is for sovereign governments or corporations. Borrowers in these markets routinely structure their debt profiles assuming they can repay debt by borrowing new money later.

The International Monetary Fund’s Global Stability Report, released last week, focused in large part on sovereign rollover risk. The risk of a country failing to find lenders has spiked.

This is essentially what happened to Greece in May. It planned to meet an $11.9 billion bond repayment by selling more bonds. As concerns about its ability to meet this payment swelled, investors grew skittish about lending the country money.

Canada needs to raise a little more than 10% of its gross domestic product to repay maturing debts through the end of next year. Italy’s needs are closer to 20% of GDP, according to the IMF report.

Japan needs to scrape up half its annual economic production to pay off maturing debts. In explaining why Japan was unlikely to “dysfunction,” the IMF cited a stable investor base — not dependable tax revenues or fiscal discipline.

Contrast that with the most fiscally troubled states. According to its annual report for fiscal 2009, California is facing about $2.9 billion in debt maturities this year and a similar amount next year — less than 0.4% of the state’s GDP. Illinois will have to repay about $1.5 billion in principal this year and next, or 0.3% of its GDP.

The totality of state and local governments’ interest paid and debts retired or refinanced in 2008 was 2.4% of U.S. GDP.

Aside from its diminutive size, what is noteworthy about this figure is how stable it is over time. In 2007, state and local governments’ interest paid plus debts retired or refinanced in 2008 represented 2.3% of U.S. GDP. The figure has stayed between 1.97% and 2.66% since 1995.

Not so for the federal government, which based on current debt outstanding will next year spend 6.9% of current GDP repaying interest and principal, followed by a spike to 8.5% in 2012.

Friedland said there are plenty of issuers that have sold bonds to finance projects, and could budget for the interest and principal payments on those bonds for years without accessing the market again.

“We view the fact that there is significantly less use of bullet maturities by municipal issuers as a credit positive,” said Nicholas Sourbis, a managing director at the bond insurer National Public Finance Guarantee. “The fact that municipal issuers tend to favor level debt service doesn’t mean they’re not reliant at all on market access … it just means that they’re less susceptible to problems refunding maturing debt than, for instance, sovereign issuers.”

A good illustration of the perils of rollover risk can be found in Bell, Calif., which according to its latest annual financial report has a $35 million lease revenue bond maturing next month.

For a city with about $10 million in annual property tax collections, paying off the principal is impractical. That forces Bell to turn to investors for the money to repay the debt, at a time when the city has gotten tremendous amounts of  bad publicity over exorbitant salaries to city managers. The California attorney general’s office Thursday said it plans to seek a court order placing Bell under some sort of receivership or monitoring.

“This one has a balloon payment coming due, and is not exactly a popular credit,” said Richard Ciccarone, head of municipal research at McDonnell Investment Management. “You’re dependent on either the bank or the bond market to cover you. … This is why level debt service is much more manageable. A credit like that is going to have a very hard time trying to pull off a payment of $35 million from internal sources.”

A Financial Crisis Inquiry Commission report in May fingered rollover risk as a principal culprit in the financial crisis. Banks became overly reliant on short-term financing vehicles like asset-backed commercial paper and reverse repurchase agreements. When some banks were unable to roll these over, they faced insolvency.

The IMF last week found the biggest threat to banks is not mortgage credit or toxic assets, but their own liabilities. Banks have not done much to lengthen the maturity of their liabilities since the crisis, the IMF found, and they need to refinance more than $4 trillion of debt over the next two years.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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