Back-It-Yourself Debt Adds Risk to Munis as Issuers Shun Banks

After five years of paying Citigroup Inc. for bond guarantees that became too expensive to renew, Massachusetts state debt manager Colin MacNaught issued $538.1 million of notes without bank backing.

Pennsylvania’s Turnpike Commission and the District of Columbia also sold a new kind of debt with no bank support this year, boosting the total 94 percent from 2009 to $2.96 billion, data compiled by Bloomberg show. The securities, called Sifma index notes, pay interest tied to the weekly average of other variable-rate debt, 0.31 percent as of June 23, according to the Securities Industry and Financial Markets Association, a New York-based trade group.

The new notes show how municipal finance has entered a different world following the worst credit crisis since the Great Depression. Before the bankruptcy of Lehman Brothers Holdings Inc. in 2008, state and local governments were able to take advantage of low interest rates by selling securities with adjustable yields and counting on Wall Street firms to buy them back if investors wouldn’t bid. Now, issuers are depending less on the banks to be purchasers of last resort.

Borrowers are taking that risk to cut costs as tax revenue fell in 34 states in the first quarter, according to the Nelson A. Rockefeller Institute of Government in Albany, New York. The $67 billion decline in the 12 months ended June 30, 2009, was the largest on record, U.S. Census data show.

Cash on Hand

“The risk is that if you refinance this note in five years and we’re in a stagnant interest-rate environment, or possibly a declining one, demand for it will probably fall,” Kenneth Gambone, head of short-term public-finance banking at Barclays Capital, said at a Bloomberg Cities & Debt Briefing in March.

The Port Authority of New York and New Jersey wants to do without a bank letter of credit and rely on its own cash and holdings of U.S. government securities as backing for a $500 million commercial paper program, Treasurer Ann Marie Mulligan said at a June 22 finance committee meeting.

Sellers of securities without guarantees take the risk that changes in interest rates or their creditworthiness could make it difficult to refinance. While hundreds of borrowers take that chance every year, things can go wrong.

Harrisburg, Pennsylvania, has weighed bankruptcy because it may not be able to refund $35 million of three-year debt coming due this year. The bonds were used for improvements to a trash-to-energy incinerator that operates at a loss, making access to capital “uncertain” for the authority that oversees it, a Moody’s Investors Service report said.

‘Direct Look’

In the absence of bank backing to assume some of the risk, “investors are taking a direct look at the issuers,” said Joanna Brody, a principal at Piper Jaffray & Co. in Minneapolis.

That’s what Nuveen Asset Management did in buying at least $8 million of the back-it-yourself debt. Its holdings include an eight-month District of Columbia note and a two-year Massachusetts issue for a short-term bond fund, according to Bloomberg data.

“Our analysis starts with the borrowers’ credit, just like other bonds,” said Paul Brennan, a portfolio manager in Chicago for Nuveen, which holds $65 billion of municipal securities.

Peter Hayes, who oversees $106 billion of municipal bonds at New York-based BlackRock Inc., said the floating payments of the Sifma notes “appeal right now” as investors may benefit should interest rates rise from near-record lows. He declined to say if BlackRock holds any of the debt.

Less Volatile

Prices of the few Sifma floaters that traded since their initial sale have held close to par. That makes them a substitute for variable-rate demand bonds, which are in short supply, Nuveen’s Brennan said.

“We can earn a higher tax-exempt yield than a variable- rate demand bond with less volatility than a fixed-rate bond,” said Patrick Quinn, senior portfolio manager at Northern Trust Bank in Chicago, who bought $3 million of District of Columbia floaters for a short-term bond fund.

Massachusetts will save about $7.45 million on the $538.1 million of Sifma index notes it sold March 11, Treasurer Timothy Cahill said after the offering. The state may also reduce its use of interest-rate swaps to further lessen banks’ role in its borrowing, MacNaught said.

The Sifma notes are “a much simpler, straightforward product,” MacNaught said in a telephone interview from Boston. Their maturity is known in advance, so there is time to prepare for a refinancing, which may consist of new fixed- or floating-rate debt, he said.

$147 Billion

The floaters allow issuers to borrow at interest rates as low as variable-rate obligations without paying for bank guarantees used to assure money-market funds they can redeem their holdings on demand. Such funds can buy Sifma-index issues due in less than a year, while longer-maturity issues are attracting buyers from short-term bond funds, Gambone said.

The high cost of bank guarantees will prompt more municipal borrowers to use Sifma notes, said Piper Jaffray’s Brody at the Bloomberg Briefing. At least $147 billion of bank agreements backing variable-rate demand bonds expire in the next year, Bloomberg data show.

Interest rates on the notes Massachusetts sold change with the Sifma index’s weekly average for variable-rate demand bonds. The rate has averaged 1.47 percentage points less than for top-rated 10-year bonds over the past five years, according to Bloomberg data.

Downgrade Risk

Yields on one-year Massachusetts Sifma notes are equal to the index. To compensate investors for the risk that the state’s credit might worsen, the two-year issue pays Sifma plus 0.24 percentage points, sale documents show.

The three-year has a yield of 0.38 percentage point over Sifma and the four-year adds 0.53 percentage point, according to the documents.

While those securities pay more than the $536.7 million of variable-rate demand bonds they replaced, and Massachusetts will face underwriting costs when they’re refinanced at maturity, the state will save money overall by avoiding bank-guarantee fees.

Before the March sale, Massachusetts received bids to replace the expiring Citibank guarantee that were about seven times higher than the 0.12 percentage point it paid five years ago, MacNaught said. Prices ranged from an average of about 0.8 percentage point for a one-year agreement to 0.9 percent for three years, he said.

“This refunding was a chance for the commonwealth to reduce its counterparty risk and to reduce its borrowing costs,” Cahill said in his March 15 statement.

Fewer Swaps

The debt is rated AA+ by Fitch Ratings and Aa1 by Moody’s Investors Service, the companies’ second-highest municipal grades, and AA at Standard & Poor’s, the third-highest.

Massachusetts may also consider doing without interest-rate swaps, such as those linked to its Sifma-indexed notes and their variable-rate predecessors, MacNaught said. Those derivative agreements with banks allowed the state to lock in fixed rates to protect against rising costs for their floating-rate debt should interest rates rise.

In the future, Massachusetts may use fewer swaps and rely on increased returns on its short-term investments, which average between $1 billion and $2 billion, to offset higher floating-rate debt costs if interest rates rise, MacNaught said.

Trying to lock in interest rates with derivatives can be costly for municipalities because floating-rate debt is cheaper than fixed-rate bonds “most of the time,” said Robert Brooks, professor of finance at the University of Alabama in Tuscaloosa.

The risk of rising borrowing costs “isn’t as great as you would think” because governments’ cash and taxing authority produce more revenue as inflation quickens and interest rates rise, he said.

“Excessive avoidance of floating-rate debt is a huge strategic error for local governments,” Brooks said, “an error their bankers don’t tell them about.”

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