Taxable Bond Sales Double With Penalty at 1994 Low: Muni Credit
Localities from Florida to California are selling taxable bonds at the fastest pace in three years as the additional cost of issuing the debt instead of tax-free financing is near the lowest since 1994.
Issuers in the $3.7 trillion municipal market have sold about $16 billion of taxable debt this year through May 3, more than double the tally of $7.5 billion a year earlier, data compiled by Bloomberg show. It’s the fastest start since 2010 for the securities, which give municipalities more leeway in how they use proceeds. This week’s biggest local-debt sale is a taxable offer from Illinois.
The jump in sales hasn’t derailed a rally in the securities, which have gained 2.5 percent this year, beating the 1.5 percent earned by tax-free munis and 1.4 percent for company debt, Bank of America Merrill Lynch data show. The extra yield states and cities pay to sell 10-year AAA taxable bonds rather than those exempt from levies is 0.47 percentage point, close to a 19-year low set in March.
“Our strong preference is always to use tax-exempt debt because it’s a lower cost,” John Sinsheimer, Illinois’s director of capital markets, said in an interview from Chicago. “However, the penalty for using taxable debt in this market is not that severe.”
Illinois, the lowest-rated U.S. state, is set today to issue $300 million of taxable bonds backed by sales-tax revenue. The debt is rated AAA by Standard & Poor’s, six steps higher than Illinois’s general-obligation grade.
Local governments sell taxable bonds when the issues don’t meet Internal Revenue Service standards for tax-exemption, such as for pension funding because the money is invested to make a profit. Nonprofits such as universities and hospitals are among the most-frequent borrowers, said Mikhail Foux, a municipal strategist at Citigroup Inc.
Taxable munis represent about 13 percent of the $119 billion states and cities have sold this year, Bloomberg data show. That’s up from 6.4 percent for the same period in 2012.
The year’s biggest taxable deal was a $2 billion offer from Florida Hurricane Catastrophe Fund Finance Corp., a state-run nonprofit that sells protection to insurers. States including California, Illinois and Michigan have also issued taxable general obligations, Bloomberg data show.
“There’s pretty good appetite for taxable municipals, and we’ve seen evidence of that in the larger issues,” said Peter Coffin, president of Breckinridge Capital Advisors in Boston. The firm oversees about $18 billion of local bonds, of which $500 million is taxable.
Taxable munis have benefitted from higher yields relative to fixed-income assets such as Treasuries and corporate bonds, Coffin said.
Top-rated taxable local debt maturing in 30 years yields about 3.94 percent, Bloomberg data show. That compares with 3.79 percent on similar-maturity AAA corporates, according to Moody’s Investors Service data. Treasuries due in 2043 yield 2.99 percent. (USGG30YR)
With so-called crossover buyers from other debt markets snapping up the wave of taxable muni issuance, the yield spread on local debt over company securities has narrowed to about 0.15 percentage point, close to the lowest since 2008 and down from a high of 2.57 percentage points in September 2011, Bloomberg data show. The yield gap on taxable munis over Treasuries touched the lowest since 2007 this year.
“A lot of high-grade investors recognize that they can get more yield with very little additional risk with municipals,” Coffin said.
Five Moody’s-rated municipal issuers defaulted in 2012, according to a report this week from the New York-based company. By comparison, 15 U.S. corporations graded by Moody’s defaulted through the first four months of 2013.
IRS guidelines prohibit municipalities from selling tax-exempt securities if they meet the agency’s criteria of a “private activity bond” or “arbitrage bond.” A city can’t issue tax-free debt if more than 10 percent of proceeds will go toward private business and if more than 10 percent of principal or interest payments are secured by private property. Bonds can lose their tax-exemption if the terms are violated.
The century-old exemption on interest from municipal debt is being debated in Washington as politicians consider ways to generate revenue and curb the federal deficit. President Barack Obama’s fiscal 2014 budget released last month proposed limiting the benefit.
With restrictions on tax-exempt proceeds, issuers such as universities and hospitals are turning to taxable munis for more flexibility, Coffin said. Florida’s hurricane fund borrowed in April to boost its cash balance, and used taxable debt because of IRS rules, said Jack Nicholson, its chief operating officer in Tallahassee.
The constraints also extend to states that are looking to boost investment and development after the 18-month recession that ended in June 2009.
“There are timing, purpose, and administrative issues which can make it difficult to issue the bonds tax-exempt,” Terry Stanton, spokesman for Michigan Treasurer Andy Dillon, said in an e-mail about the state’s $200 million taxable school bond sale last month. “Additionally, in the current market, the rate differential is negligible.”
Tax-free local bonds have yielded more than their federal counterparts for 36 of the past 40 trading sessions, Bloomberg data show. A muni-Treasury ratio above 100 percent compares with an average of 92 percent since January 2001.
A higher ratio means tax-exempt debt is relatively cheaper for investors and more expensive for issuers to sell, which has helped propel taxable municipal issuance among localities, Citigroup’s Foux said.
At 1.78 percent, yields on benchmark 10-year munis compare with 1.77 percent for like-maturity Treasuries. The ratio of the two yields is about 101 percent, meaning local debt is trailing federal securities.
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