Business Insider

Peter Crabb: Municipal bond sales fall as bond investors look elsewhere

The bond market is speaking out again. The market for U.S. Treasury bonds often reacts strongly to new federal government policies or changing conditions in the national economy.

The loudest cry these days, the biggest price reaction, is in the market for state-level bonds.

With nearly $3 trillion in bonds outstanding, the market for U.S. municipals, or munis, is large. Earlier this year it looked as if an investment bubble was building in the municipal bond market. That bubble may be bursting after significant declines in muni bond prices this week.

Munis are any bonds issued by state, county, or local governments. A key benefit for muni investors is the federal tax exemption. The interest earned on a state, county, or local government bond is not taxable at the federal level for any investor. The interest earned is also tax-free at the state level if the investor is a resident.

For example, Bingham County, Idaho, schools have bonds maturing in 2015 that paid 4 percent interest to investors when issued. Idaho residents with income in the 28 percent federal tax bracket earn a taxable-equivalent interest rate of 6.2 percent on these bonds.

Safety is another strong motivation for municipal bond investors. There are some headline grabbing examples from the past, like New York City and Cleveland in the 1970s, but the historical default rate for munis is only 1 percent. This compares to more than 6 percent for U.S. corporate bonds.

The muni market today isn’t looking so safe.

The Nuveen Barclays Capital Muni Bond Index has fallen 7.5 percent from its high in late August. As state governments grapple with weak economic conditions and troublesome pension liabilities, muni bond investors are looking elsewhere for safe returns.

According to recent data from Merrill Lynch, U.S. municipal bonds with maturity dates between seven and 12 years out now yield 3.6 percent, well above the low of 2.4 percent this summer, and higher than the yield on a taxable U.S. Treasury bond of the same maturity.

On a tax-equivalent basis, state and local governments must now pay bond investors nearly two percentage points more than what they can earn on U.S. Treasuries. A growing federal government debt is certainly a national concern, but like all politics, the more pressing problem is local.

The global financial markets have not punished the federal government for continued high deficit spending. The Treasury Department reported this week that foreigners were once again net buyers of long-term U.S. financial assets in October, the most recent month of data.

Net purchases of U.S. Treasury notes and bonds totaled $23.5 billion. The biggest buyer is again China, holding more than $906 billion in U.S. government debt.

Meanwhile, municipal bond sales are falling fast. Reuters reports that November was the weakest of the year in the muni market.

Not surprisingly, some states have it worse than others. Idaho has maintained a strong credit rating for all its bonds. Moody’s currently gives Idaho an AA rating. AAA is the best. California holds the lowest state rating at only single A.

The significant decline in municipal bond prices, and the corresponding rise in interest rates, is a strong reminder to state legislators to mind our fiscal p’s and q’s. States that don’t hold down expenses while tax revenues remain low in the weak economy will pay dearly in the debt markets.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.