Soaring Bond Yields Drive States, Cities to Buy Back Own Debt
(Bloomberg) — Investors’ swift retreat from a key corner of the municipal-bond market is causing state and local governments to take matters into their own hands.
Governments are wading into the variable-rate market to drive down borrowing costs on the bonds with interest rates that reset daily or weekly. The municipal-bond market’s steep sell-off last month led yields on the debt to surge as money managers dumped them to raise cash, costing municipalities as they were facing higher expenses from battling the spread of the coronavirus.
The steps by officials to buy back some of their localities’ own debt signal some concern about the health of the state and local bond market even after the Federal Reserve last month included purchases of variable-rate debt as collateral as part of its lending program for money market funds. Yields on an index of the securities fell 2.9 percentage points on Wednesday to 1.83%, still higher than the 0.92% that the index has averaged over the last five years.
Pasadena, California, is among local governments that saw rates skyrocket amid the turbulence in March, with rates on its tax-exempt securities jumping as high as 5.77%, much more than the average yield of around 1%. Meanwhile, the city is steeling itself for lost revenue from the shutdowns implemented to slow the spread of the outbreak.
Related: Hospitals, Cities Hit by Surging Interest Rates in 2008 Echo
The city council on March 30 authorized officials to amend bond indentures to allow the city to buy back their own variable-rate demand obligations should they fail to be remarketed.
“It’s a good strategy to have in place just in case, because nobody knows how long this COVID-19 crisis is going to continue, how bad it’s going to get, and how the market’s going to react,” said Vic Erganian, Pasadena’s treasurer.
The municipal-bond market niche saw yields soar in March after investors concerned about the impact of the coronavirus dumped the easy-to-sell securities, pressuring the banks that serve as the buyers of last resort on the securities. Dealer inventories of variable-rate debt surpassed $30 billion, six times where inventories normally are, BlackRock Inc (NYSE:). said in a report Monday.
Hospitals Get a Hand
Hospitals battling the coronavirus outbreak were also hit with higher borrowing costs right as they face a cash crunch of their own as elective surgeries are postponed. Ohio and Pennsylvania’s treasurers started a program to buy variable-rate municipals issued by their state’s respective hospitals to blunt the impact of the higher yields.
The Ohio state treasurer’s office said its investment arm would start bidding on hospital bonds at interest rates of 2%, with the capacity to invest $900 million in such debt, according to a statement last month. At least eight hospitals, including the Cleveland Clinic and the Nationwide Children’s Hospital, are participating in the program, according to treasury spokeswoman Brittany Halpin. The office has purchased $150 million in bonds so far.
“To the extent the program is needed to ensure normalized rates, the Treasurer’s office is willing to continue the program for the duration of the declared emergency,” Halpin said in an email. “It will be revisited on a weekly basis and could expand or contract as the state Treasury’s liquidity needs require.”
Pennsylvania’s treasury office launched a similar program, saying the yields on variable-rate bonds “have not fully normalized,” according to a press release on April 2.
The state’s cash pool will be allowed to purchase $240 million in debt sold by Pennsylvania hospitals and is looking to cap the interest rate at no more than 2%. The state plans to reevaluate the program after 30 days.
There may be unintended consequences when issuers buy back their own bonds. S&P Global Ratings, which rates about $145 billion in variable-rate debt, said in a report on April 3 that there are problems with this approach. The ratings company said debt issuers could lose the participation of banks providing a letter of credit or standby purchase agreement if they purchase their own bonds.
And municipal agencies may find buying their tax-exempt debt tricky because the Internal Revenue Service may consider the securities extinguished and so they couldn’t be remarketed as bearing tax-free interest, said Richard Moore, president of the National Association of Bond Lawyers.
The group on March 25 sent a letter to the IRS and Treasury Department urging a temporary suspension of the rules to give the issuers relief, as was done after the 2008 crisis.
“Liquidity nearly dried up a couple of weeks ago. The course of the pandemic and the financial markets is unclear,” Moore said by email. “The time to reinstate these provisions (with a few minor improvements) is now, so that issuers will be able to avail themselves to these provisions immediately if liquidity does in fact dry up.”
The Idaho Power Co., which saw rates spike to 5.2% on March 25, said in a regulatory filing that it may seek to purchase its bonds, citing the volatility in the market. It’s unclear whether the agency has done so — the yields on the debt reset to 2.15% on April 1. Brad Bowlin, a spokesman for the company, declined to comment beyond the regulatory filing.
Pasadena, which has $134.7 million in tax-exempt variable-rate debt, is trying to avoid further stress within the state and local debt niche. The city bought its own taxable debt after the credit crisis in 2008 and held it for about a month to two months, according to Erganian, the treasurer. Once the market normalized, they were able to sell back the bonds to investors.
Cities are preparing for a major economic hit as the virus-induced shutdowns crater revenue sources like sales taxes and income levies. Municipalities also rely on money from tourists who visit and spend money. In the city that’s home to the Rose Bowl, hotel occupancy alone has plummeted to 10% from 80%, according to a presentation to the Pasadena city council.
Monthly debt costs for the city’s tax-exempt debt were typically about $129,000 a month, Erganian said. If they persisted, the higher rates seen over the past few weeks could add up to $200,000 to $500,000 more per month.
“This will be like a double whammy,” he said.
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