U.S. municipal borrowers should be grateful for Dexia Group’s bailout last weekend.
The bailout is a credit positive for U.S. muni bonds with backing from Dexia, as it should give the Franco-Belgian lender enough liquidity to navigate through the European sovereign crisis and gives U.S. borrowers time to find replacement liquidity providers, market participants said.
“From a liquidity point of view, the bailout is certainly a big support for Dexia,” said Tom Ceusters, managing director of Dexia Credit Local. “The markets seem to be comfortable with the Dexia name and currently most investors that carry Dexia-enhanced bonds don’t look necessarily at the liquidity facility but look at the underlying bonds.”
Over the weekend, France, Belgium and Luxembourg came to a 90 billion euro agreement to bail out Dexia. Dexia Bank Belgium will be bought from Dexia for 4 billion euros by the Belgian government and the French will start a new bank to finance local authorities. The remaining residual bank, Dexia Credit Local, will benefit from a government guarantee on new liabilities up to 90 billion euros.
On Tuesday, Fitch Ratings downgraded Dexia Bank Belgium to A and affirmed Dexia and Dexia Credit Local at A-plus.
As of Friday, Dexia’s exposure in the U.S. municipal market was down to $9.4 billion, which is “significantly reduced” both as a percentage of the total variable-rate muni debt market as well as in absolute dollars, Ceusters said. Dexia has been reducing its exposure since 2008 when it held $54 billion of letters of credit and liquidity facilities for floating-rate bonds.
“In a nutshell, it’s no big deal,” said Citi muni analyst Mikhail Foux on the effects of the bailout on the U.S. muni market. “The recent developments are relatively benign and the problems won’t disappear, but they are moving in a positive direction.”
Foux added that potential buyers should be looking at high-quality variable-rate demand notes backed by Dexia with high failure rates. “The VRDN market is robust and there is enough capacity,” he said.
General market consensus agrees. “Most issuers that have Dexia LOCs will be able to replace them with other providers,” said Alan Schankel, managing director at Janney Capital Markets. “And so it should not have an overwhelming impact on the muni market.”
Interest rates for most Dexia-backed bonds did not spike dramatically after Moody’s Investors Service on Oct. 3 threatened to lower the lender’s ratings. But they have risen over the past few months as the eurozone debt crisis heated up.
“We have not seen a spike in interest rates recently,” Ceusters said. “Rates have been stable over the past couple weeks from between 2% and 2.5% for the bulk of paper trading.” Since May, when the sovereign crisis intensified, rates have jumped to 2.5% levels and stayed there, he said.
John Hallacy, director of market research for Bank of America Merrill Lynch, said the big runup in spreads between Dexia versus other providers happened a few weeks ago. With the bailout plan, spreads should tighten measurably.
While borrowers could be in trouble if short-term interest rates spike, most of the defensiveness has already been built into tax-free bond rates, according to John Mousseau, managing director at Cumberland Advisors. “I don’t see the whole thing as a problem given that what limited exposure there is, is getting cured,” he said.
Some of the big-name issuers of Dexia-backed LOCs that have seen interest rates decline include the Municipal Electric Authority of Georgia, which saw interest rates on its bonds fall to 0.75% in October from 3.5% in June. Las Vegas Valley Water District bonds saw its interest rates fall to 2.5% in October from 3% in June. Bonds issued by the New York City Transitional Finance Authority saw interest rates fall to 0.55% in October from 1% in June, and the New York City Municipal Water Finance Authority bonds saw yields fall to 0.7% in October from 2% in June.
VRDNs backed by other banks have much lower interest rates.
Some think interest rates for Dexia-backed bonds could continue to climb. “Some daily resets are hitting over 3%,” said Matt Posner, director at Municipal Market Advisors, adding that issuers will face an even higher rate and in many cases an accelerated repayment of principal if bondholders exercise their tender option.
“While the amount of debt is relatively small in comparison to the overall amount of municipal bonds outstanding, affected issuers could find their fiscal position negatively impacted,” Posner said.