While the proposal from the Government Finance Officers Association to raise the small-issue bank-qualified limit to $30 million will be helpful in increasing the demand for smaller municipal credits, there are two major holes.
First, many institutions will have tax-loss carry-forwards for a while and cannot benefit from tax-exempt income anyway and, second, it will not really help the larger-scale capital programs that will be part of the "infrastructure" revolution put forth by President-elect Barack Obama's incoming administration.
There is a critical mismatch in the municipal bond market, and one that will become more pronounced going forward. The maturity structure of the average municipal bond issue is long. In most cases, for new-money financing, the average maturity is greater than 10 years, and in many cases greater than 20. Most individual investors buy bonds inside of 10 years. The municipal tender-option bond programs helped to bridge this mismatch by converting long-term municipal into shorter-term, money market fund-eligible securities, through TOB certificates sold to money market funds. Much of the infusion of retail cash into the tax-exempt market came from investors looking to invest in tax-exempt money market funds. Without TOB sponsors intermediating this conversion, much more new issuance will remain in its original long-term bond form. Institutional buying support for the long end of the market has been decimated, and will likely only get worse. Consequently, these bonds will have to trade at higher relative yields to entice otherwise taxable investors to the party.
One untapped source for support could come from endowments, foundations, and public pension funds.
Endowments, foundations, and public pension funds have very long-term investment horizons, as they attempt to match assets with liabilities, and seek to maximize long-term appreciation. They follow rigorous asset allocation strategies to minimize portfolio volatility, often searching for non-traditional asset classes to provide uncorrelated risks to dampen overall volatility.
Unfortunately for municipals, domestic endowments, foundations, and certain pension funds are generally not taxpayers. They are largely not-for-profit creatures. Consequently, they have never been a real buyer of cash market municipal bonds, but some have participated in the muni market through SIFMA index-based derivatives (swaps and structured notes) municipal credit derivatives and public-private partnership projects.
The index-based products are attractive on a historical risk/reward valuation basis, and are relatively uncorrelated with other fixed-income market investments. Perfect for attributes for efficient portfolio construction. The credit derivatives provide credit diversification, while producing taxable income.
These endowments and foundations also share another key attribute - they are much like the not-for-profit borrowers in the municipal market. They understand the business model of a hospital, a university, or a cultural institution.
To encourage investment from this pool of hundreds of billions, if not trillions, of investable dollars, the federal government needs to consider providing special tax credits. This is value in lieu of the value obtainable through tax- exemption.
For example, a special rule could be created that if the owner of a tax-exempt bond was a non-taxpayer, the owner could receive credits from the federal government. Presumably, this would lower municipal borrowing rates, open up the market for buyers of long-term municipal bonds through domestic interest, and provide better asset diversification for domestic endowments and foundations at a time when other risky investment categories (i.e., hedge funds) have blown up.
Matthew Roggenburg is a managing director at Cityview Capital Solutions LLC.