The Milken Institute’s Center for Financial Markets and Georgetown University’s Center for Financial Markets and Policy at the McDonough School of Business recently held the latest installment of their MATH aEUR~Markets And The HillaEUR(TM) briefing series. The briefing focused on the municipal bond market.
The panelists included Natwar Gandhi, Former Chief Financial Officer for the District of Columbia and Adam I. Cohen, Vice President and Portfolio Manager for Fortigent LLC. The session was moderated by Sandeep Dahiya, associate professor at the McDonough School of Business.
The speakers discussed municipal bonds and their importance as a funding tool for cities, states, and local governments. They also discussed the causes and impact of Detroit filing the largest municipal bankruptcy in U.S. History, and the future outlook for the municipal bond market.
Muni Bond Market:
The panelists explained the function and the current state of the $3.7 trillion municipal bond market. Municipal bonds are debt obligations issued by cities, states, and local governments to fund public-purpose projects like schools, hospitals, airports and other public facilities and infrastructure. There are two types of municipal bonds: revenue bonds and general obligation (GO) bonds. Revenue bonds are backed by the revenues generated by the particular project being financed by the bond issue aEUR" for example, toll roads. GO bonds are backed by the full faith, credit, and taxing power of the issuer. Municipal bonds are an attractive form of investment for retail investors because they are exempt from federal, and occasionally state, taxes. Retail investors are the largest holders of securities in municipal bond markets, owning nearly 75% of outstanding principal amounts of municipal bonds.
The muni bond market has experienced significant change since 2008. Bond insurers largely left the marketplace following the global financial crisis. As a result, municipal bonds are typically no longer protected by an insurance wrap, and, accordingly, are no longer viewed as a guaranteed form of investment. The panelists agreed that this change may contribute to the sectoraEUR(TM)s inability to return quickly to its pre-2008 levels.
Further putting pressure on the muni bond market, a number of municipalities, including Jefferson County, Alabama; Stockton County, California; and Harrisburg County, Pennsylvania have had to file for bankruptcy over the past few years. Detroit is the latest and most prominent example but may also be somewhat unique. The panelists explained that the Detroit filing aEUR" estimated to be the largest ever in the U.S. at about $18 billion aEUR" was mainly attributed to a remarkable decline in the cityaEUR(TM)s tax base; from 2000-2010, Detroit lost nearly 25% of its population. Similar to other municipalities, Detroit also suffered from years of excessive borrowing as well as unfunded pension and health care liabilities.
On a more optimistic note, the panelists shared their views on lessons Detroit and other struggling cities can learn from the experience of Pittsburgh in turning a city around. In the mid-1980s, Pittsburgh suffered significant economic decline as a result of competition from Japanese and Korean companies that flooded the market with low-cost steel. But, the city was able to reinvent itself by working with new industries, including in healthcare, in an attempt to modernize and diversify its economy. The University of Pittsburgh Medical Center is today not only the cityaEUR(TM)s, but also the stateaEUR(TM)s, largest employer, and a key driver of growth.
The panelists argued that despite the recent selloff in muni bond markets resulting from the Detroit bankruptcy and expectations of Fed tapering, fears over the sector may be overblown. It remains an open question whether retail investors who comprise the majority of the buyers of muni debt will be able to stomach volatility tied to current events. Underscoring that concern, investors will be closely monitoring how bondholders are treated in the ongoing Detroit bankruptcy proceedings.
From a state and local perspective, governments will need to address public sector finances and potential funding gaps before deficits hit critical levels. The panelists noted that it would be wise to learn from the Detroit and Pittsburgh divergent experiences.
Finally, at the federal level, policymakers will need to monitor the potential impact new financial market rules and regulations may have on the muni bond market. More specifically, there is some concern that the Volcker rule may reduce the market making activities of certain financial institutions that fear tripping a ban on proprietary trading. Additionally, proposed Basel III risk weightings may discourage banks from holding municipal bonds in their portfolio. Any significant decrease in participation could have an adverse effect on the $3.7 trillion muni bond market.