Mournful Muni Experts See End of an Era

CHARLESTON, S.C. — Market experts on Thursday painted a bleak picture of the municipal securities market over the next few years, saying the high bond volume of the past six years is gone and unlikely to return.

At a three-day conference of the National Federation of Municipal Analysts, market experts stressed that even with recent signs of a muni market rally, significant pressures remain on state and local governments. They range from federal spending cuts and possible legislative restrictions on tax-exempt bonds to hostility among some congressional Republicans, who view bond projects as wasteful government spending.

Their remarks came as the House Ways and Means Committee’s oversight panel weighed the Public Employee Pension Transparency Act, a bill sponsored by Rep. Devin Nunes, R-Calif., that would prevent state and local governments from issuing tax-exempt, tax-credit or direct-pay bonds if they failed to file annual reports with the Treasury Department disclosing certain information, including how they calculate their unfunded pension liabilities.

The bill also would require governments to value their pension assets and liabilities using a so-called riskless rate of return pegged to a Treasury rate of 4-5%, which is lower than the more broadly used historic rate of return, generally 7-8%.

“The golden days of new-issue bonds in the muni market are behind us for an extended period of time,” said George Friedlander, chief municipal strategist at Citi.

Specifically, he predicted that the muni market’s overall 2011 volume will peak at $240 billion, with $100 billion coming in the first half of the year and the remainder in the second half.

It could take years, or perhaps even decades, Friedlander said, before bond volume approaches the ranges of between $400 billion and $430 billion that were seen during the six years before 2011. In the next three years, he predicted bond volume will be at or just above $300 billion, rising from there in later years.

“This is the bottom year for volume and we rebound from here,” Friedlander said.

A key driver in the reduced volume, he noted, is the shift in policy priorities at the federal level, especially on spending cuts and deficit reduction. At the same time, state and local governments are grappling with dwindling tax revenues from the prolonged recession.

Federal officials, he said, will reduce the federal deficit by pushing costs onto state and local governments.

“I don’t see any way that will not happen,” Friedlander said.

At the state and local level, he noted, many officials have embraced a new austerity about spending and borrowing, deferring bond issuance until absolutely necessary.

“Cutting ribbons used to be a politically popular thing to do,” Friedlander said. “Now cutting ribbons equals being a spender and it’s a politically unpopular thing to do.”

Other panelists and speakers at the conference echoed his concerns.

“I do think the muni market is in transition,” said John Dillon, chief municipal bond strategist at Morgan Stanley Smith Barney, noting he has seen a recent rally and expects continued improvement in the second half of this year.

“This market has a lot of sentiment to it,” he said. “It can turn on a dime.”

Dillon added, however, that long-term concerns remain, though he did not include widespread defaults by state and local governments among them.

By July, he said, most state governments will have weathered the process of balancing their budgets, and most will do so on time. That alone, he said, should dampen speculation and fears about states declaring bankruptcy or defaulting on debt.

“It’s not going to go away,” Dillon said. “But the market should feel better about it.”

Still, he worries that a default by one issuer, especially a local government, could rattle confidence.

“I think this has become a very idiosyncratic market,” Dillon said. “For munis, something happens to one issuer and the whole thing goes into convulsions.”

Another panelist, meanwhile, stressed that retail investors have not fled the market — at least not yet.

In the fourth quarter of 2010, Federal Reserve data show individual investors held 37.5 % of outstanding munis, while mutual funds, the second largest holder, had 18%, according to Elliot Mutch, a vice president of municipal research at Bank of America Merrill Lynch.

But with negative headlines about the munimarket lingering, Mutch cautioned, retail investors remain “very skittish.”

Frustrations with recent media coverage of the market dominated a panel discussion Wednesday, titled “Munis in the Media: Headline Risk and Municipal Bond Analysis.”

During a question-and-answer session, analysts in the audience grilled two journalists who cover the muni market, Jeannette Neumann of the the Wall Street Journal and Mary Williams Walsh of the New York Times.

One exchange focused on analyst Meredith Whitney, who appeared on “Sixty Minutes” in December and predicted 50 to 100 municipal-bond defaults.

An audience member pressed Walsh about why she hadn’t written a story to debunk Whitney’s research after learning, from an executive summary of Whitney’s report, that she had not mentioned muni defaults at all, but rather a default on the social compact.

“Isn’t that a story?” the audience member said, sparking a burst of applause.

Walsh said she thought Whitney had already received enough attention.

In a separate exchange, an analyst asked whether the reporters vetted sources or checked their backgrounds as municipal researchers.

“We take very seriously who our sources are,” Neumann said. “We try to be very, very careful.”

Elsewhere at the conference, market participants and issuer groups signaled opposition to — and suggested an uphill battle for — congressional efforts to tinker with the tax-exempt status afforded muni bonds.

In a panel discussion Wednesday on the fiscal outlook for state governments, Scott Pattison, executive director of the National Association of State Budget Officers, said states will be “extremely aggressive” about any attempt to abolish tax-exemption for municipal securities.

“This is not an immediate threat,” he added.

An issuer on a separate panel Thursday noted that the municipal market is a product of federal tax laws, which are written by Congress.

“As such, what they giveth, they can take away,” said Frank Hoadley, Wisconsin’s capital finance director.

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