Investors value the returns from state and municipal bonds for two primary reasons. The exemption of interest they receive from federal income tax is best known, but the sovereign authority of state and local issuers to raise taxes to cover debt service, even for projects supported by revenues produced by private enterprises, is as important as the tax exemption.
The value of that benefit may decline, however, if investors too often see public issuers playing fast-and-loose with due diligence to finance economically dubious projects.
The advent of environmental sustainability projects in the past decade has introduced a new kind of uncertainty into municipal debt offerings. Municipalities have often made overly optimistic projections based on certain costs, but uncertain potential revenues, the combination of which has, at least in a few instances, created very real hardship for municipal Issuers.
Adding to the uncertainty municipal issuers are currently facing is the extent to which policy changes will affect their budgets. The National Association of Counties recently warned that local governments should not count on the 6%-8% of their budgets they have been receiving from the federal government in recent years.
There also is uncertainty about interest rates. It is not about the direction of the Federal Reserve's interest rate policy but the timing and magnitude of potential changes it will adopt.
Now that the magnitude of the increase is clear in light of the recent interest rate increase, the question becomes how much of a squeeze it and expected future increases will create for municipal budgets.
States and municipalities were already facing higher debt service due to the 4.5% increase in outstanding debt that was put on their balance sheets in the past year, according to the St. Louis Federal Reserve Bank. The last thing municipalities need at a time like this is the failure of a high- profile, mixed-waste project due to faulty projections and poor due diligence.
Unfortunately, several localities are facing that very situation, at significant cost to their taxpayers.
Municipalities typically go to great lengths to ensure they address all contingencies and risks when building bridges, wastewater treatment plants, or projecting water needs decades into the future. It appears in some cases that less due diligence has been done for plans to build recycling hubs.
Of course, a plethora of federal and state subsidies propelled interest in and financial support for such projects in recent years. What didn't increase, though, was the supply of recyclable plastics, cans, cardboard, and paper. Nor was there an increase in the demand for the waste.
Nevertheless, that didn't stop some municipalities that relied on the unrealistic projections built upon such untrustworthy assumptions.
For instance, the city of Montgomery, Alabama, funded a $35 million mixed-waste facility with $29 million in tax-exempt revenue bonds. The facility opened in 2014 but closed 18 months later due to depressed prices for waste commodities and lower-than-anticipated volumes. The city ultimately assumed the debt.
Likewise, a $90 million waste plant in Hampden, Maine, ran out of money not long after opening, saddling local taxpayers with $50 million in debt with no revenues to help pay the debt service. Mercifully for taxpayers, the project has a tentatively happy ending: A firm with private equity backing paid the city $3 million for 90% ownership of the facility, although it took them two years to get the plant restarted.
Perhaps the most troubled mixed-waste project is in Lane County, Oregon. In its haste to get its $150 million CleanLane waste-sorting facility running, the county fumbled in multiple ways. For starters, it failed to consider $23.5 million in interest costs for a $35 million bond issue to provide up-front funding. Then, it paid $1.5 million to buy a site before receiving the special- use permit needed for the location. It fought the denial of the permit, incurring $275,000 in legal fees for an unsuccessful court battle. Finally, it paid $1.2 million for a feasibility study on an alternative site.
The missteps created delays that added $12,000 per day to the project's cost. Even completion of the project failed to end the litany of costs for county taxpayers. The contract required the county to deliver 120 million tons of recyclable waste each year to the facility, and a failure to meet that minimum would cost $78.69 per ton of shortfall. In 2025, the county collected less than 78,500 tons. At that rate, the county would have to pay an extra $6.2 million annually in return for nothing.
It is difficult enough to manage state, city, and county budgets and debt in the best of times. In an era where the federal government is pulling financial support and interest rates are rising, the dubious nature of sustainability projects has only made the balancing act less manageable.
It is time that investors pay more attention to credit quality of tax-exempt issues and not just their tax exemption or sovereignty. They will need greater transparency and perhaps more stringent regulatory oversight of municipalities to ensure that taxpayers and bondholders are not left holding the bag on these kinds of short-sighted projects.
