How Do Governments Use The Municipal Bond Market?
Monday, September 14, 2009
How can local and regional governments overcome the massive debts they've been facing lately? Many are turning to the municipal bond market as a way to bring in additional revenue. We'll speak to a former municipal bond trader about how the financial instruments are used, and to discuss what's happening with the bond market right now.
MAUREEN CAVANAUGH (Host): I'm Maureen Cavanaugh, and you're listening to These Days on KPBS. The way many San Diegans were first introduced to the ins and outs of the municipal bond market was when San Diego was thrown out of it. Starting in 2004, the fallout from the city's underfunded pension crisis prevented the city from issuing debt in the form of bonds. That market freeze-out ended for San Diego last year, and now the city is free once again to take part in the municipal bond market. But just as San Diego's problems have eased, California's municipal bonds suffered a hit this year when a key rating agency gave the state the lowest credit rating of all fifty states. Bond Buyer's 19th Annual California Public Finance Conference is taking taking place in Carlsbad this week, and joining me for a quick tutorial on the municipal bond market and where it might be headed is my guest Jeff Horn. He's senior vice president for RBC Wealth Management in Los Angeles, and he was a municipal bond manager for 20 years. So, Jeff, welcome to These Days.
JEFF HORN (Senior Vice President, RBC Wealth Management): Thank you, Maureen. It's a pleasure.
CAVANAUGH: I want to ask you what you thought of the President's speech today on Wall Street?
HORN: I think it was a very good speech. His main focus was talking about normalcy and we can't turn normalcy back into complacency. The risks that we went through over the last year since the Lehman Brothers collapse has been gigantic, and many people are thinking that the world is back to where it was, and his main point was that it's not there and we need to be aware of it and we need to have continued regulation in the markets.
CAVANAUGH: And so far as that goes, do you agree with him?
HORN: I agree completely, Maureen. I don't think most investors measure risk correctly and it's something that needs to be addressed on a dynamic basis.
CAVANAUGH: Well, Jeff Horn, I introduced you as someone who had managed municipal bonds for 20 years. I wonder if you could give us a quick tutorial. What are municipal bonds? How are they used by governments?
HORN: Thank you. Municipal bonds are bonds that are issued by cities, states, school districts to borrow money for large capital projects. An easy comparison would be when you're buying a house, you get a mortgage on a house. When the City of San Diego needs to borrow money for a major capital improvement, they go into the bond market to borrow money in large chunks. They don't pay for it all at one time. They pay for it over time just like we pay for a house. And the two types of bonds that are issued are general obligation bonds, bonds that are secured by taxes, and there are revenue bonds, bonds that are secured either by sewer revenue, water revenue, hospital bonds, bonds for stadiums that get revenue from stadium revenues, and the like.
CAVANAUGH: And as you know, and as I said in my introduction, San Diego was frozen out of the bond market for several years. What kind of a hamper does that put on a city or a municipality if they can't – if they can't issue debt in the form of bonds?
HORN: If they can't issue debt, they can't do infrastructure work, they can't build new schools, they can't repair sewer lines, they can't get new power lines, they can't build new civic centers. There's no way that a municipality will have the cash flow to pay off something up front. Builders want their money just like on a house. They want their money up front, and you pay for it over a 30-year period of time, or maybe a 10-year period of time. And without the ability to go into the market for new money, it's a tremendous burden on any municipality.
CAVANAUGH: Now, traditionally speaking, hasn't the idea – hasn't it been that the idea that buying municipal bonds is a very secure form of investment?
HORN: Oh, sure. People have always talked about municipal bonds as one of the safest investments. And the main reason they are, they're second only to U.S. Treasuries because they have the ability – municipalities, in a general obligation form, have the ability to raise taxes as much as necessary to pay off the principle interest on the bond. You get the full faith in credit of a municipality when you get a voter approved general obligation bond that you're buying. The municipality needs to raise taxes as much as they can to pay off that debt. Corporations can't do that, only governments can.
CAVANAUGH: Now, there must, however, going back to the president's speech, there must be some risk involved in that process. Tell us what the risks are involved for both the city and the investor in the use of municipal bonds.
HORN: Sure, the city has many requirements when they're issuing the bonds in terms of covenants and restrictions to issue them, so it's not as much on their side. The bond buyer needs to be sure that they're under full understanding of the maturity of the bond they're buying, how long it is, what the credit rating of the bond is, what the interest payment of the bond is going to be, and when the interest payment is due. And because the markets trade, unfortunately, not always rationally, those bonds may move up and down in price based upon sentiment, not based upon fundamentals. We saw happen over the last year during the financial crisis, that many municipal bonds traded at a huge premium to where they used to trade, meaning the yields on them were much larger than many market participants thought they should be yielding because of the fear. Bond investors were buying Treasury bills when they thought they were going to lose all their money because they looked at Treasury bills as the safest investment possible. And municipalities and corporate debt traded down in terms of price, higher in terms of yield.
CAVANAUGH: Right. I'm speaking with Jeff Horn. He's senior vice president for RBC Wealth Management. He was a municipal bond manager for 20 years. There is a big bond buyers annual conference taking place in Carlsbad this week, and we're talking about the municipal bond market and where it might be headed. And, Jeff, the financial rating services, Moody's, this past spring—it might have something to do with what you've just been talking about—gave a negative financial outlook on the credit of all U.S. municipalities. How has that affected the bond market?
HORN: Great question. Rating agencies are looked at by investors as a third party opinion. It's not the buyer's opinion, it's not the seller's opinion, it's someone else that should be completely unbiased. And when people see credit ratings go down, they think that the security is not there, therefore you have to pay more interest on the bonds, whether new issues or bonds that you would buy in the secondary market, in the after market. And when the rating agencies decrease a rating of a municipality, it drives rates higher, so it's never a good thing to happen when you're a bond buyer to see your bonds that you already own go down in terms of price. It's a great thing to happen if you believe, as your own opinion, that interest – that the security of the bond is going to be fine and you can buy bonds at a cheaper price because other people's sentiment has driven up the yield and down the price.
CAVANAUGH: Well, as I said in the opener, California's municipal bonds got a – have now been rated the lowest of any state. The credit rating of California, the lowest credit rating of all 50 states. And what does that do to the state's ability to issue bonds?
HORN: Well, it doesn't necessarily affect their issuance because the state needs to borrow money when they need to borrow money but it has driven up the rates. The state of California has if not the highest, one of the highest yielding bonds now of any state that's issued of the 50 that are out there. So it has driven rates up so high that you can now get yields on California municipal bonds that are higher in yield than U.S. Treasuries. Remember, municipal bonds issued by the many municipalities through the state but the State of California bonds are exempt from federal and state tax, so you can get a tax-free bond now yielding more than you can get if you buy a U.S. Treasury.
CAVANAUGH: But doesn't the risk increase when the credit rating goes down?
HORN: Well, that's a – that's the issue, Maureen. That's the third party opinion, that's someone else's feeling that the state has problems. There's been rumors around that the state of California is going to declare bankruptcy, and if you listen to our Treasurer, Bill Lockyer, he reiterates the fact that the state cannot declare bankruptcy. They're constitutionally prohibited from doing that.
CAVANAUGH: I wonder, Jeff, how has the bond market affected – been affected by the whole thing that we've seen? This whole recession, the collapse in the housing market, the overall economic crisis, what effect has had – that had on the bond market over the past year to 18 months?
HORN: Great question. It had a terrible detrimental affect on people's perception of what can happen with municipal bonds because if the property tax revenue goes down to a state or a city or a county, that's the money that's used to pay off the bonds. So many bond holders thought that as the housing prices in a specified area decline dramatically or not dramatically, the paying ability of that municipality will go way down. The great thing about municipal bonds is that they have both a revenue stream and there's also assets underlying that revenue stream so when the state or a county or a city was having financial problems over the last year and the bond prices went way down, many investors realized that the municipality has the ability to raise taxes if they need to pay off the bonds, and you, as a bondholder, also have that underlying asset. The State of California has trillions of dollars worth of assets and only billions of dollars worth of debt outstanding. So what we would, in our business, call the coverage of the bonds continues to be very high albeit smaller than it was. And as we see the economy look like it's coming back a little bit, many bond market participants feel a little more comfortable owning bonds at this time.
CAVANAUGH: Now there is some talk, though, in the financial world about municipal bonds, perhaps municipal bond defaults being the next financial crisis. Do you see that happening?
HORN: In my thirty-some years in the business, the number of general obligation bonds that we've seen default in the state of California you could count on one hand. And there are hundreds of thousands of issuers of municipal bonds throughout the country. It could potentially lead to a problem, Maureen, but remember municipal bonds have that ability to raise taxes that a corporation doesn't have so as you see a financial crisis develop and you know you have assets underlying the bond plus a tax base, albeit a declining tax base, the security of the bonds is still second only to Treasuries.
CAVANAUGH: Now, what about those entities that don't have, necessarily, the ability to raise taxes. I'm thinking of schools and airports. They use bonds as well. So I'm wondering, how are those entities using bonds nowadays?
HORN: It's much more difficult. Just like you or I in a financial downturn, we're not going to necessarily borrow money because we're going to question if we can pay it back. The municipalities that issue general obligation bonds don't have that problem but a bond that's issued straight – that's issued that only has a revenue stream behind…
HORN: …it may be less apt to actually issue bonds in this kind of market environment and the bond holders may question some of the security behind it.
CAVANAUGH: Now as a former municipal bond manager for 20 years, and vice president of RBC Wealth Management in Los Angeles, Jeff, I'm wondering, where do you see the bond market in helping the U.S. economy in its recovery? What form is that going to take and what should we look for?
HORN: As we saw in Los Angeles, the infrastructure has problems. There was just a giant sinkhole out in the San Fernando Valley that was caused by a water main breakage. And the City of Los Angeles is spending about $3 billion to try to redo their infrastructure. You'll see that happening in San Diego, through the state, through the country. And the only way that these municipalities can pay for this will be the issuance of bonds. The federal government is doing everything they can and they've allowed bonds to be issued in a new type form that we've never seen called Build America Bonds. Those bonds are taxable bonds issued by municipalities that have a 35% backing by the U.S. government and it's to encourage development, it's to encourage a lot of retrofitting of the – of America to make us a little bit stronger, and it's a great source of financing that is not available. The corporations can't do it. Only municipalities have that type of issuance ability.
CAVANAUGH: And have you seen cities start – and municipalities start to take advantage of these new types of bonds?
HORN: Yes, ma'am. The State of California has issued them. They've been issued all throughout the country. It's become a very large issuer of bonds and some people are even saying that it's crowding out the normal municipal finance arena. But we continue to see municipal bonds being issued in fully taxable form also.
CAVANAUGH: That's interesting. So is the California state government also using the bond market to help pay down its debt?
HORN: They don't use it to help pay down its debt. They use it to finance projects.
CAVANAUGH: Right, right.
HORN: Starting next week, you're going to see a $10 billion California revenue anticipation note that will be issued that's going to have a maturity of less than one year.
CAVANAUGH: And I'm wondering, Jeff, what do you see down the line, let's say in the next quarter for the bond market and also how it's affect – how that might affect the general economy.
HORN: Well, as long as the bond market is open and people can buy bonds, sell bonds, and issuers like the cities and the states can continue to sell bonds, it provides a source of financing that can provide thousands and thousands of jobs throughout the country, which is something that we need. And without that type of financing, it'd be very difficult to do some of the projects that are necessary. And this will help in the recovery process, I'm hoping, and the new normalcy can be something that actually be back to somewhat normal, the way we were a year ago.
CAVANAUGH: Just as the president was talking about earlier today.
CAVANAUGH: Well, thank you so much. You have given us a quick tutorial. I think I know a lot more than I did starting out, Jeff, and thank you for that.
HORN: My pleasure, Maureen. Thank you.
CAVANAUGH: I've been speaking with Jeff Horn. He's senior vice president for RBC Wealth Management in Los Angeles. And I want to let everyone know that they can post their comments online at KPBS.org/TheseDays. And coming up, stay with us, a preview of tonight's season opener for the Chargers. It's next here on KPBS.
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