NEW YORK, Nov 20 (Reuters) - Investors in New York City's debt have had it good. Two decades of prudent fiscal management have pushed its bond prices higher, driven its borrowing costs lower, and the city's economy has flourished despite a fiscal crisis, the lingering aftermath of Sept. 11, 2001 and, more recently, Superstorm Sandy.
Now the election of the city's first Democratic mayor in 20 years, who is promising to take the city in a new direction, has made investors sit up and take notice.
Bill de Blasio has promised an overhaul of generous business incentives and wants to increase taxes on the city's top earners. He also has to cut a deal with city unions who are demanding up to $8 billion in retroactive pay increases as part of a new contracts that outgoing Mayor Michael Bloomberg has left for his successor.
To keep bond holders on its side the new administration needs to assemble a credible budget team capable of closing looming budget gaps, address burgeoning employee costs that are eating up a large chunk of the city's $70 billion budget, and not give away too much when it settles contract disputes with public labor unions.
"We will carefully be monitoring the new mayor's ability to effectively negotiate manageable pay increases," said Konstantine Mallas, who helps run a $400 million New York state bond fund for T. Rowe Price. Mallas described union negotiations as one of the biggest risks to the city budget with the potential to be very "burdensome."
Mallas said that he is holding off buying more city debt until the situation is clearer.
"I have not been adding to the name recently," said Mallas. "There has been a slight reduction but it still is one of our larger holdings." He declined to say how much city debt the firm holds.
On the more extreme end is Wilmington Trust, which manages $4.3 billion in municipal assets, and has sold all of its New York City bonds with maturities longer than four years. The firm declined to disclose the dollar amount of the bonds sold or the size of the remaining holding.
To be sure, Wilmington picked a good moment to sell, admitting that New York bonds' strong performance means it is an opportune moment to lock in profits.
Still, Wilmington money managers cited a raft of gripes about de Blasio from his opposition to stop-and-frisk policing that they say could lead to increased crime and his support for the Occupy Wall Street demonstrations.
"I hope we're wrong. We love New York City," said Ted Molin, senior municipal credit analyst at Wilmington.
De Blasio's transition team strongly rejects any notion that New York would decline under the new mayor's policies.
"These insinuations aren't just wrong. They're completely irresponsible," said a spokeswoman for his transition team.
"Mayor-elect de Blasio will work with people across every industry to make New York safer and more prosperous," she said. "He will pass a fiscally responsible budget, increase public safety by giving the NYPD the tools they need to fight crime, and negotiate fair contracts that treat workers with respect while also safeguarding taxpayer dollars."
SELLING NOT WIDESPREAD
Selling of New York's debt is not widespread and most investors appear comfortable holding it. The premium investors get to own city debt has averaged about 40.5 basis points over top-rated municipal debt this year. Since de Blasio won the primary on Sept. 10 it has averaged 48 basis points. It has also been higher than that recently, hitting 50 basis points in June.
But any sign that bond vigilantes will take the city to task by pushing up its borrowing costs would be blow for the new administration at a time when it is seeking new revenue to bring in signature measures such as universal pre-school.
That is one reason why de Blasio has taken pains to explain to investors that he intends to preserve the city's credit standing.
Tony James, president of asset manager Blackstone Group , believes worries about de Blasio's administration and policies are unfounded.
"Bill is certainly aware of the importance of preserving the city's creditworthiness and he has made that clear to me in our discussions," said James in emailed comments. Blackstone does not invest in municipal debt.
New York City is one of the biggest issuers in the $3.7 trillion municipal bond market, with over $40 billion in general obligation debt outstanding, about $11,400 for each of the city's 3.5 million tax payers.
Investing in city debt has been a win for investors, pushing yields on 10-year New York City general obligation debt to 3.1 percent this week, 0.47 percentage points above triple-A rated municipal debt, compared with a spread of 1.5 percentage points in 2009. Bond prices and yields move in opposite directions.
But the city's budget illustrates some difficult decisions may be looming. Annual city spending on employee benefits - such as pensions and healthcare - as well as debt service has doubled in the last decade to nearly $30 billion, or almost 40 percent of the budget. The city estimates that those liabilities will grow another 16 percent to $35 billion by 2017.
PENSIONS AND CONTRACTS
New York City's pension funds are only 60 percent funded, according to a recent survey by Morningstar. That is well below the 80 percent usually seen as a minimum safety threshold and one of the lowest of the 25 cities covered.
"Labor contracts are going to be important, putting controls on some of the fixed costs - pensions, healthcare benefits - is going to be important. Depending what you can do on that side that might direct how you raise revenues and to what degree you raise revenues," said Joe Pangallozzi, a credit research analyst at money manager BlackRock.
BlackRock stressed that it "has no active sell program on New York City credit." The firm runs a New York state debt fund with about $240 million in assets, according to Morningstar.
Bloomberg and unions let the previous contracts run out between 2009 and 2012 without much effort to reach a new deal, allowing Bloomberg to avoid open strife with labor and the union to wait for a more sympathetic negotiating partner.
The Bloomberg administration estimates retroactive pay increases for public sector unions could cost the city $4 billion to $8 billion, and in addition in forecasts a budget gap of $2.2 billion next year.
(Additional reporting by Hilary Russ; Editing by Dan Burns, Peter Henderson and Tim Dobbyn)