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U.S. Muni Bond Market Shrinks as States, Cities Cut Debt

June 7 (Bloomberg) -- U.S. states and local governments kept paying down debt during the first three months of 2012, contributing to a bond drought that has helped fuel a rally in the municipal securities market.

State and local government debt shrank at a 1.8 percent annual rate from January through March, the fourth quarterly drop in the last 15 months, the Federal Reserve Board said today on its website. That cut the size of the municipal bond market by $11.3 billion to $3.73 trillion. The change may be short-lived as bond sales have picked up since March.

States and localities, which unlike the federal government typically can’t borrow to pay bills when tax collections fall short, have been issuing less debt for public works projects as they focus on closing the budget shortfalls that have lingered since the 2007 recession.

In 2011, state and local government’s debts dropped for the first time since 1996, according to the Federal Reserve. With bonds scarce, prices rallied, driving a 14 percent gain last year in Bank of America Merrill Lynch's U.S. Municipal Large Cap index.

John Hallacy, head of municipal research at Bank of America, said today that he expects new bond sales to pick up and rise to $330 billion this year, a $60 billion jump from 2011.

While borrowing costs for municipalities are at their lowest in a generation, a majority of new bond issues are raising money to refinance higher-interest debt.

Hallacy said so called new-money bond issues, which raise cash rather than refinance old debt, account for about 40 percent of new bond deals for 2012, up from 35 percent earlier in the year. Hallacy, who spoke today at the State & Municipal Finance Conference hosted by Bloomberg Link in Chicago, said he expects such borrowing to increase later this year.

“In the last few weeks there have been more new money transactions,” Hallacy said. “We tend to think there will be more new money transactions later in the year.”

To contact the reporter on this story: William Selway in Washington at wselway@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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