By Martin Z. Braun
July 21 (Bloomberg) -- The market for municipal bonds whose interest rates reset daily, weekly or monthly exhibited “substantial strains” in the first half of 2009, in contrast with long-term municipal debt, according to a report to Congress by the Federal Reserve.
Local governments, nonprofits and hospitals that issued the debt, which offers borrowers short-term interest costs on longer-term bonds, are paying more for bank backstops that ensure bondholders can redeem their investment, the Fed’s Monetary Policy Report said. The cost to insure these variable- rate demand obligations, or VRDOs, is also increasing.
“Some municipalities were able to issue new VRDOs, but many lower-rated issuers appeared to be unwilling or unable to issue this type of debt at the prices that would be demanded of them,” the report said.
Even as U.S. states and local governments are facing the biggest declines in tax revenue since World War II, the Federal Reserve is opposing a U.S. House Financial Services Committee proposal to guarantee repayment of variable-rate bonds.
The Federal Reserve has “important misgivings” given “the potential for decisions about the provision of credit to states and municipalities to assume a political dimension,” said David Wilcox, deputy director of the Fed’s research and statistics division in May 21 testimony to the House Financial Services Committee.
Falling Tax Collections
State tax collections fell 11.7 percent in the first three months of this year compared with the same period in 2008, the largest drop in at least 46 years, according to the Albany, New York-based Rockefeller Institute of Government.
Yields on more than $90 million of A+ rated bonds issued by East Baton Rouge, Louisiana are 0.55 percent compared with 0.32 percent for top-rated debt whose interest-rate resets every seven days.
Short-term bonds issued for Cathedral High School, a nonprofit college preparatory school in Indianapolis, Indiana, yield 5 percent. The Cathedral High school bonds are backed by a letter of credit from Fifth Third Bancorp. The letter of credit carries a BBB+ rating from Standard & Poor’s.
The market for the short-term municipal debt collapsed last year, when the insurance companies guaranteeing the bonds lost their top credit ratings because of losses on securities tied to residential mortgages.
Auction-rate securities fell apart in February 2008 as banks that provided support for two decades abandoned the market, stranding investors with notes they couldn’t sell and borrowers with interest rates as high as 20 percent.
SIFMA Swap Index
The Securities Industry and Financial Markets Association seven-day swap index, which is used to measure top-grade, floating-rate bonds, rose to 7.96 percent in the wake of the Lehman Brothers Holdings Inc. bankruptcy last September. It had been 1.79 percent.
The SIFMA index has fallen to 0.32 percent as of July 15, suggesting the short-term market is functioning for higher-rated issuers, the Federal Reserve said.
In contrast to the short-term market, the market for traditional, fixed-rate municipal bonds is healing. Issuance of long-term debt rose to $110.6 billion in the second quarter from $84.4 billion in the prior quarter, while 20-yearmunicipal borrowing rates fell to a 17-month low of 4.44 percent in May.
To contact the reporter on this story: Martin Z. Braun in New York atmbraun6@bloomberg.net.
