Outlook 2009: Health of municipals hinges upon economy, insiders say; retail interest may decline

By Cristal Cody and Sheri Kasprzak

New York, Dec. 31 - The beginning of 2009 in the municipal bond market may see a lot of overflow from a 2008 year-end that exploded with new issues, but the fate of the rest of the year may depend upon broader economic factors, said market insiders.

Retail investors, who make up a good portion of the municipal bond-buying audience, were growing wary of offerings at the end of the year, both in the primary and secondary markets. This occurred despite the most new-issue offerings in the market in six years.

"It's the time to buy," said one sellside source interviewed by Prospect News in December.

"Yields are way up, but retail investors seem to be cautious. The best investment I can think of right now [the end of 2008] is a tax-exempt, long-end municipal from an issuer with good credit."

The short end, said another sellsider, is a bit rougher, but the issuer's credit rating makes a big difference.

"I think there's a lot of fear in the marketplace on the shorter end," he noted.

"If you go out 20 or 30 years, it's less scary. It's a volatile market right now, so if you've got a short-term bond or note, you're going to see some wild movements. It smoothes out substantially on the longer end."

Not everyone is optimistic, however, that yields will remain quite as high in 2009.

"I think eventually yields are going to go back down again," said one sellside market source.

"Look at it this way. The economy is bad. Municipalities are going to be struggling to pay their debt. The high-rated issuers are the ones with the advantage, but with financial crises come ratings downgrades. I think I can safely say we won't be seeing 9% yields on 30-year bonds that often next year. Yields might be higher than average. That might linger for a while in the beginning of 2009, but I wouldn't expect it to be a trend to last through the year."

Another factor hindering the market at the end of 2008 was an absolute glut of offerings up for grabs. In September, when market conditions were shaken up and Lehman Brothers Inc. filed for bankruptcy, issuers put off their planned sales and sat on their hands. In December, however, new offerings boomed and some issuers found themselves battling for liquidity.

Lack of liquidity

Rick Dreher, director of Pennsylvania's Bureau of Revenue, Capital & Debt, recently told Prospect News that a dearth of liquidity in the municipals market forced the commonwealth to reduce its planned $600 million competitive sale of general obligation bonds to $300 million.

"The liquidity isn't there in the market to get these bonds sold," he said at the beginning of December.

"I think I saw somewhere that there's a $20 billion backlog [of new offerings] since September when Lehman Brothers filed for bankruptcy."

The lack of liquidity also forced Miami-Dade County in Florida to reduce the size of its $350 million offering of G.O.s to $172 million.

PANYNJ gets people talking

The one deal that got lots of municipal professionals talking at the end of 2008 was, strangely enough, a deal that didn't get done.

The Port Authority of New York and New Jersey tried to sell $300 million in series ZZ consolidated notes competitively near the beginning of December. The offering failed to draw a single bid.

The failed sale - a first for the PANYNJ - set tongues wagging in municipals circles, and most market insiders were surprised that an issuer with such a good credit rating could not pull in any interest from underwriters.

"For that particular issuer, it's surprising," one sellsider pointed out just after the failed deal. "I think it really says a lot about how bad the market has gotten."

The taxable nature of the offering may have been its downfall, and it certainly didn't stop other issuers of tax-exempt competitive offerings from running out onto the playing field.

"It's a scary situation to be in," said one market insider of the PANYNJ failed competitive sale.

"I'm sure they're fine without the deal for now, but it was one of those things where you stopped and took notice. Will it get done in 2009? Probably. But the fact that an issuer with a good credit rating couldn't get a bidder for a competitive sale is a big warning for others."

Another sellsider said that he feels confident other competitive deals will do just fine 2009.

"I think it's partly a liquidity issue and it's partly an end-of-the-year issue," he said.

"The retail investors are looking for tax-exempt bonds, and even those investors are getting harder to come by. I feel pretty good about 2009, at least the first few months. After that, it gets harder to tell. My feeling is, the economy might improve a bit by the end of the year and, if so, I think that means good things for munis. If not, we may have lower volume."

Other big-name deals

The PANYNJ offering wasn't the only one that moved insiders to talk this year. After months of slim pickings in the competitive market, Pennsylvania poised itself to sell $600 million in G.O. bonds. Priced in December, it would have been the largest competitive sale since September's market collapse and the bankruptcy of Lehman Brothers Inc.

Instead, the issuer ended up cutting the sale in half.

"The [Pennsylvania] deal was a huge indicator of how things can deteriorate and how issuers need to be flexible when the market goes bad," said one sellsider.

"I think they handled it well - as well as they could. But everyone was talking about that big competitive deal for a long time."

California bonds rejected

Moving out west, California has found itself with a lack of investor interest as well.

The state's bonds were widely courted in early 2008 and then rejected by the end of the year. The rejection is likely to continue until well into 2009, according to the state treasurer's office.

On Feb. 7, 2008, individual and institutional investors were hungry for California's $3.183 billion in economic recovery bonds. Retail orders totaled $1.46 billion, with the rest sold to institutional investors at a true interest cost of 2.997%, with 3% to 5% coupons that yielded 2.05% to 4.1%.

The proceeds from those bonds were used to help finance a portion of the state's accumulated state budget deficit.

But by Oct. 1, the state announced it would run out of cash reserves that month unless it could sell billions of dollars in revenue anticipation notes.

On Oct. 16, California sold $5 billion in revenue anticipation notes, upsized from a planned $4 billion offering, with a 4.48% true interest cost.

The proceeds were used for the state's cash flow management needs while a budget continued to be hammered out among the state's lawmakers.

Even so, by December, a budget still hadn't been passed and the state had run out of money. That month, the California Pooled Money Investment Board ended $3.8 billion in financing for infrastructure projects since the funds had to be used to keep schools, hospitals and government offices open.

The board's decision stops all new infrastructure loans through June 2009, bars increases to existing loans and prohibits agencies from spending any more funds available under existing loans.

The agency plans to decide in early January whether to allow exceptions for certain projects if the financing cutoff risks financial penalties or prevents the state from paying required loan interest.

According to California treasurer Bill Lockyer, the money the board lends to projects is replenished when the state sells bonds.

Budget spiral hurts investor interest

As California's budget spiraled downward in 2008, so did investor appetite.

During the last two months of 2008, the state's lack of a budget solution combined with the faltering economy and tight credit nationwide to keep bond investors away in droves, said California treasury spokesman Tom Dresslar.

"Investors don't have confidence in California right now. They don't view California bonds as quality investments," he said. "There's just not the interest there among institutional investors that we need to be successful in the market."

Since the state cannot sell bonds, it will have to stop providing an average of $660 million in loans every month for startup and cash flow financing for infrastructure projects, according to the treasury office.

Dresslar said the freeze on infrastructure bonds will remain in effect after the budget problems are addressed, although a budget in place is critical.

"The first step toward getting back into the bond selling business is to get our fiscal house in order," Dresslar said. "We're focused right now on trying to do whatever we can to help enact a budget solution that opens the door to the bond markets."

On Dec. 18, the California Legislature passed an $18 billion budget rescue plan that if ultimately approved would offer a step toward returning to the markets.

Puerto Rico's action uncertain

Looking to other issuers, Puerto Rico may have been active in the bond market in 2008, but uncertainty lingered at the end of the year over the level of issuance for 2009. This uncertainty remains due to new leadership emerging in the commonwealth.

"There will be a whole new administration and a new approach," said Steven Anreder, a spokesman for the Government Development Bank for Puerto Rico.

"It's very difficult to see what [the debt activity] is going to look like going out," he said.

Puerto Rico sold billions of dollars in debt in 2008, including $1.461 billion in revenue and revenue refunding bonds on March 6, 2008.

Default concerns linger

Investors who did get in on municipals in 2008 are likely sweating it out over potential defaults in 2009.

Defaults more than tripled year over year in 2008, and some market insiders expressed concern that this would continue into the New Year. The subprime housing crisis has impacted many municipalities, slashing their tax base and making defaults more of a possibility.

Jefferson County, Ala., was likely the most infamous default story of the year, compounded as it was by the arrest of the city of Birmingham's mayor on charges of corruption linked to the issuance of municipal bonds and debt swap agreements.

At the end of 2008, the county was still on the verge of defaulting on $3.2 billion in sewer bonds and was in the process of filing for bankruptcy. Should the county go bankrupt, it would surpass Orange County, Calif.'s debt when it filed for bankruptcy in 1994 by almost twice.

"The subprime crisis is going to be felt for a long time to come," said one sellside source.

"I think a lot of potential investors are worried about the possibility of default at this point. It's certainly something they've thought less about in the past because munis are supposed to be a fairly safe investment. I'm not so sure that's the case anymore. It's riskier. I think the key now is choosing carefully. Credit ratings mean more now than ever."

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