State and municipal budgets are running historic deficits, and from the steady diet of less than appetizing economic news, are unlikely to rebound anytime soon. What does it mean for yield in the municipal bond market, a sector that’s seen dramatic change in the past few years? We asked Robert Bigelow, vice president and director of tax-exempt fixed income strategies of HighMark Capital Management Inc.
There have been dramatic changes to the municipal market over the last several years. What new challenges are municipal investors facing?
The most significant has been the demise of the bond insurers. The penetration of the bond insurance market had been growing since the 1980s, peeking at about 50% of annual issuance, before falling to its current level of well below 10%. This Maginot Line had created a false sense of security for bond holders, while commoditizing the market. A prime example of this is to look at the spread between the 10-yr. AAA G.O. vs. the 10-yr. Insured Certificate of Participation (COP). In February 2008 that spread was 9 basis points, and as of the end of August 2010 this spread had increased to 148 basis points. Investors are now looking through to the underlying issuers’ credit.
What structural changes do you see in the municipal market?
The biggest is the advent of the “Build America Bonds.” The American Recovery and Reinvestment Act means municipalities can issue debit in either tax-exempt form, or taxable with 35% of their interest expense rebated from the U.S. government. Since the taxable market is so much larger, this allows municipalities to access a much larger pool of investors that would not benefit from a tax-exempt bond. This increase in aggregate demand has shifted about 30% of issuance in 2010 from tax-exempt to taxable, lowering net interest costs for municipal borrowers.
The ability to issue BABs under the Act is set to sunset December 31, but it has been so successful it is likely to be extended, albeit at a lower federal subsidy rate.