There is plenty of reason for caution in the public bond sector. Prices in the muni market hit a two-year low on January 14 and yields on AAA-rated 30-year issues broke 5 percent for the first time since January 2009, according to Reuters.
The New Jersey Economic Development Authority triggered the losses on Thursday by announcing that the rising cost of issuing debt compelled it to reduce a bond offering by 40 percent, to $1.1 billion. Investors are worried that other public issuers will have trouble refinancing their debt during the next few years, when a wave of maturities must be addressed in both the public and private sectors.
The average yield on AAA rated muni bonds hit 5.01 on Thursday, according to Reuters.
This wave of maturities—which has been referred to as a “wall of debt”—is a particularly big problem in the public sector. Private equity companies have practically made a sport out of renegotiating their leveraged loans, kicking out their maturities well into the future in exchange for a higher yield or a slice of equity. Harrah’s, the gambling company owned by Apollo Management, TPG and other investors such as John Paulson, is but one financially challenged company that has restructured its debt. That allows such companies to buy more time to make their operations more efficient, invest in new lines of business and hope for a boost from a slowly recovering economy.
Investors are usually willing to cooperate with management in such situations, because they know they may face worse if the company goes into bankruptcy.
The prospect of default in the public sector is another matter, altogether.
Investors in companies such as Harrah’s are risk takers by nature, and the risk is priced into the securities at the outset. Default and bankruptcy are a part of doing business in speculative corporate debt, and an entire industry of investors and advisors has sprung up around such “work outs.”
Investors assume a much higher level of security when they put money into muni bonds. Public entities aren’t supposed to default. These issuers have the power to raise taxes, which provides a buffer between hardship and oblivion.
Defaults in the municipal market are rare indeed, but when they do happen, they have an air of catastrophe.
And the work out process isn’t as smooth as it is in the public sector—which is no picnic, either. The private sector can slash costs such as labor almost at will. But governments and other public issuers have to contend with union contracts and political pressure to maintain a particular level of service. When a public issuer gets into financial trouble, the problem is tougher to solve and the consequences of failure for investors unprepared for the worst may be quite difficult.
In the past, the existence of one or two troubled state and municipal issuers was big news. But now those problems are compounded. Much of the public sector—from issuers at various levels in California, Illinois, New Jersey, Pennsylvania, Rhode Island and New York, among others—is at risk.
A massive wave of defaults is unlikely, experts say. But the prospect that even a few might default is enough to raise borrowing costs for all, making the resolution of this mess all the more difficult.
And there’s still a chance that the most bearish views on this market—including a stern warning from Warren Buffett, who told Congress last year that he sees a major problem in the muni market over the next five to 10 years—will be borne out.