The US municipal bond market is unlikely to cause the next leg of the financial crisis according to John Higgins, a senior market economist at Capital Economics.
“Although issuers of US municipal bonds are faced with many challenges, we think investors’ worst fears are overdone” Higgins wrote in a note to clients.
Higgins believes the muni market will remain a source of volatility but says the fears driving sentiment towards the market should not be overplayed.
He sees three reasons to be worried but believes none of them will lead to a tipping point for the market.
“First, the finances of State and local governments that issue municipal bonds have been badly affected by the recession.
Support from Washington has cushioned the blow, but federal aid is now declining,” Higgins wrote.
“Second, awareness has grown of the huge unfunded long-term liabilities of State and local governments – particularly public pensions,” he added.
“Third, some US lawmakers have raised the possibility of enacting legislation that would allow States to file for bankruptcy, an option currently only available to lower levels of government,” Higgins explained.
In all three cases the situation is not as bad as feared, he added. “The budget problems faced by State and local governments are now easing as the economy recovers. The pension time bomb can be diffused and does not have a major impact on State and local government’s current fiscal situation. And the likelihood of legislation being enacted to allow States to file for bankruptcy is remote.”
Higgins sees the chance of default on some revenue bonds whose cash flows depend on specific sources of income but sees little chance of major losses for investors on rated general obligation bonds backed “by the full faith and credit of the issuing entity.”