Friday, January 14, 2011

Mutual Fund Giant Kills Plans for Three Muni Bond Funds

How difficult is it going to get for municipalities to raise money? Very difficult.

Word is clearly leaking out that there are serious problems in the bond market and investors are starting to avoid the sector.

The mutual fund giant, Vanguard Group, just announced they are not going forward with the launch of  three planned muni bond funds. Investor demand is just not there.

"We believe that this delay is prudent given the high level of volatility in the municipal bond market," said Rebecca Katz, spokeswoman for Vanguard.

In another indication of the developing problem, the New Jersey Economic Development Authority, a governmental agency, had to cut back a planned refinancing by 40%, to $1.1 billion from $1.8 billion

due to weak demand.

Yields on 30-year triple-A rated general obligation bonds closed yesterday at 5.01%. The comparable 30 year Treasury bond is trading at 4.50%. Got that? You get tax breaks with munis, yet the yield is higher than the taxable Treasury securities. This is a sure sign of added edginess in the muni market. At the start of 2006, long term muni rates were below Treasury rates. The 20 year Treasury bond at the start of 2006 traded at 4.62%. The 20 year muni for the same period, according to bondsonline, traded at 4.55%.

WSJ is pointing out another developing problem. At the height of the financial crisis, many municipalities issued short-term letters of credit with variable rates. These letters now need to be refinanced. Here's WSJ:

Amid the selloff, public borrowers such as states and utilities face a wave of refinancing stemming from deals cut mostly during the crisis. The deals involved letters of credit from banks that were designed to keep financing costs down for government entities in need of cash.

Though the financing deals can be meant to last decades, the letters of credit underpinning them are expiring sooner. That could force the borrowers in many cases to pay higher interest rates or seek guarantees at higher costs. For the weakest borrowers, new guarantees may not be available and refinancing too costly. There are about $109 billion worth of letters of credit and similar backstops expiring this year, according to Bank of America Merrill Lynch. Some $53 billion in letters of credit alone is expiring this year, according to Thomson Reuters...The short-term squeeze is unusual in the $2.9 trillion municipal bond market. Most debt is paid back over decades. And state and local governments generally don't need to borrow money to fund their daily operations....there are parts of the market where short-term cash crunches could emerge, leading municipalities to potentially default on their debts. The risks could spill over to banks that backed bonds with the letters of credit.

"This is one area of risk the market hasn't focused on," said Frederick Cannon, a banking analyst at Keefe, Bruyette & Woods. Mr. Cannon says it is difficult to determine banks' exact exposure to such deals because they don't typically report them in their financial statements.
Problems in a $109 billion market sector are not going to crash the entire financial sector, but some  defaults, and there are likely to be some, will likely spook the broader-based muni market, making it difficult, or at least very expensive, for other muni deals to get done.

All this, though, is just a preview for the big tsunami like crisis that will hit when state and local governments run out of money to fund their huge pension liabilities.

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