The worst may not be over yet for the US Municipal Bond market.  That’s according to a recent report from the ratings agency Moody’s Investors Service.  The report shows that in 2009, the agency downgraded 279 state and local government tax-backed bonds.  That is up 244% from 2008 when Moody’s downgraded only 81 such entities.  Overall, the ratings fell for 300 revenue debt issuers, up from 133 in 2008.

While the struggles that state and local governments are facing to balance their budgets is nothing new, we are beginning to see the hardship take a toll on their credit ratings.  Those lower credit ratings will make it much more difficult and costly to issue bonds, exacerbating the problems they are facing.

I recently came across this bleak outlook for the US Municipal Bond Market written by Frederick J. Sheehan (see link below).  While this is just one man’s opinion, it’s enough to give a bond investor at least a few sleepless nights.  Some of the historical precedents he points out, especially those from the Depression Era, are chilling.

The Coming Collapse of the Municipal Bond Market (PDF)

It should come as no surprise that analyzing and quantifying “risk” are the name of the game in this economy.  The risk profile for Municipal Bonds is no exception.  Unfortunately, there may be some validity to the concept that Municipal Bonds carry more risk than anyone had anticipated.

According to a recent article in The Arizona Republic, some municipalities don’t see the benefits of the Qualified School Construction Bonds (QSCB’s) and are forgoing their use.  The American Recovery and Reinvestment Act, otherwise known as the ”Stimulus Plan”, created the QSCB’s as a way to incentivize new school construction.  The bonds are unique in that they pay no interest to the bondholders.  Instead, the bondholders receive a federal tax credit.  A deep investor market for these bonds has not yet emerged and many issuers are having to pay additional interest to bondholders to incentivize them to purchase the bonds.

In addition, the QSCB’s come with several requirements which may make them costly to implement.  The first requirement, and most punitive, is the requirement to utilize Davis Bacon Wage Labor rates.  Depending on the locality, this requirement alone can increase construction costs significantly.  It is not inconceivable that any interest savings achieved by using the QSCB’s could be eaten away via higher construction costs.  Secondly, there are significant and severe reporting requirements that go along with several of the ARRA created bonds, not just QSCB’s.  We have heard of some municipalities that are having to dedicate a full time staff person to handle the reporting requirements.  In a fiscal environment where every costs is being scrutinized, adding a position may not be palatable.

Much like most things in life, there are always pro’s and con’s associated with any decision.  Municipalities are well advised to lean heavily on their financial advisors as they work through the various funding options for new projects.

Wednesday’s $39 billion auction of 5-year Treasury notes was met with very poor demand and could drive interest rates higher for America’s increasing deficit. Two metric stood out as harbingers of disappointing results. First, the bid-to-cover ratio came in at only 1.92. This represents the lowest value for this metric in over a year and is an indicator of general investor malaise. Second, the yields for the notes came in unexpectedly higher. This would indicate that the buyers were in the position of strength in the pricing negotiations. Never a good sign if you have a vested interest in the seller, which we all do.

“It was just a horrendous result,” said William O’Donnell, head of U.S. Treasury strategy at RBS Securities in Greenwich, Connecticut. – as reported by cnbc.com

It is anticipated that today’s (Thursday) auction of $28 billion of 7-year notes could be met with equally week demand. Overall, the lack of demand and pricing ability for Treasury notes could mean that the cost of borrowing increases significantly for the US. It appears to also be a clear sign from our largest foreign and domestic lenders that we need to throttle back on our levels of debt.

If that title doesn’t scare you then you might need to check your pulse…  Reuters ran an article this morning talking about how the US Federal Reserve couldn’t understand why the yield curve reached its steepest level in history last week.  Some of the theories it puts forth include, “the economy is recovering so well so there is less need for secure government backed investments”, “China may be repositioning its portfolio of treasuries”, and “the US economy is worsening and there might be a collapse of the US dollar”.  Some of these theories are in diametric opposition to each other, providing further indication that the Federal Reserve really isn’t sure of much.

I know I only have a college degree in economics, but let me give this a try…  We know the US Government is going to have to issue roughly $2 trillion of Treasuries to fund next year’s deficit.  That will push the Supply curve for treasuries out to the right.  We also know that the US economy continues to struggle, signs of improvement are few and far between and there is a very real prospect of inflation on the horizon.  That will shift the Demand curve in to the left.  What you are left with is reduced quantity demanded for Treasuries and a reduced price for Treasuries.  A general believe that this economic condition won’t last forever, and some change will be coming amplifies the effect the further out the yield curve you go.  A lower price means a higher yield and, voila, your yield curve is steepening.  I know this is a gross oversimplification of the Treasury market, but it at least gets you heading in the right direction.

In a further sign of the distress apparent in the bonds markets, the yield curve for US Treasuries moved to its steepest level in recorded history yesterday.  The spread between 2-year and 10-year notes breached 275 basis points.  The sharp increase in yields seems to be a result of concerns over the levels of debt the US government is incurring and how they will fund the spending.  According to a CNBC article,

With $2 trillion or more in issuance seen coming to market this year alone, some dealers were looking for a sharp readjustment in bond rates—which effectively reflect the cost to government of financing its borrowing.

The treasury did experience good demand for yesterday’s auction of $35 billion of 5-year notes.  However, strong demand for shorter term notes indicates a lack of demand for longer term issuance’s.  These are the ones that typically finance many of the municipal projects that provides the local services we, as taxpayers, demand.  In addition, the increase in longer term rates has a profound effect on mortgage rates, driving them up further.  This could serve to slow the improvements in the housing market, a sector which the US badly needs to improve in order to pull it from this recession.

While the debt markets may not be the most exciting thing to watch, they are extremely important to health and well being of our economy.