Investors Fear Rising Risk of US Regional Defaults

Investors are worried that the risk of default for US local governments is growing, amid signs that some regions are facing the same type of difficulty in curbing pension and budget deficits as some eurozone countries .

The yield attached to some forms of infrastructure municipal bonds has risen relative to US Treasury bonds because of fears that cash-strapped local governments will struggle to repay these loans.

Timothy A. Clary | AFP | Getty Images A concerned trader on the floor of the New York Stock Exchange.

Absolute borrowing costs for regional governments remain relatively low in historical terms because of the Federal Reserve’s ultra-loose monetary policy . But any swings in municipal yields will be watched closely by investors, since they suggest that the fiscal anxieties about the eurozone could now infect the US.

“The risk in the second half of the year is that investor attention switches from Europe to the US,” said Robert Parker, senior adviser at Credit Suisse Securities, who singled out parts of California, as well as towns and cities in Illinois, Michigan and New York state as among the most vulnerable.

“You will see investor concern about the viability of those cities and therefore you will see, inevitably, further spread widening in the municipal bond market.”

If these market swings are sustained, they could push up borrowing costs for local governments , which, in turn, could exacerbate the squeeze on local authority finances and place more stress on the federal budget.

“There is more of a perceived risk to munis now,” said Laura LaRosa, director of fixed-income at Glenmede, a private investment manager.

US states faced budget deficits of $89 billion for fiscal 2011, which began for most of them on July 1, according to the National Conference of State Legislatures. That is after shortfalls of more than $300 billion since 2008.

Local municipalities can default and, depending on the state, file for bankruptcy. Should a state come to the brink, which is not expected at this time, many believe that it would be likely to receive federal support. The sharpest swings in the muni market have been seen in the $100 billion so-called “Build America bonds” – or Babs – a type of US muni debt that has characteristics similar to corporate bonds. This sector has attracted a fresh investor base, which is now demanding greater compensation for risk.

Risk premiums, or spreads on Babs relative to Treasuries, have risen to 228 basis points, according to an index from Barclays Capital. The spreads have climbed from a low of 161bp in early May to their highest level since Barclays started compiling the index last October.

Absolute yields have risen to 6.03 per cent from 5.97 per cent.“The problems in the eurozone have driven up fixed-income yields overseas – on banks, utilities and sovereigns,” said Matt Fabian, a managing director at Municipal Market Advisors. “Babs compete directly against those issuers for buyers.”

The cost of insuring against default for munis also has risen. However, this part of the derivatives market is rather illiquid, and the mainstream part of the muni market has not seen as dramatic a swing as the Babs sector, partly because this is dominated by a traditional base of investors. These include local buyers who receive tax breaks when they buy US muni bonds, and who have historically been relatively loyal.

The muni sector has been known for its relatively few defaults and debt service is high in the pecking order of bills that states must pay. However, the threat of default has come to the fore as some states struggled to balance budgets after years of lower revenue and as federal stimulus is tapering off.