Bond Market Different

March 16, 2008
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GRAND RAPIDS — The city of Grand Rapids, its Downtown Development Authority and Kent County all are considering entering the municipal bond market sometime this year.

The city is looking to finance waterline and sewer improvements through two revenue bonds worth up to $140 million and also restructure or refund a 1993 bond.

The DDA wants to refund the serial bond it issued in 1994 that built much of Van Andel Arena, a security with an outstanding principal of $29 million.

And the county recently announced plans to issue a bond worth up to $19 million to upgrade the solid waste disposal system.

Normally these tax-exempt issuances would be fairly automatic and would hardly receive any attention.

But the municipal bond market has changed for the worse after longtime top-rated bond insurers, such as Ambac and MBIA, strayed from their normal business practices to insure riskier mortgage-backed securities that went under with the sub-prime collapse.

As a consequence, the rating agencies reacted to those losses by downgrading some municipal insurers from their perennial triple A ratings to marks as low as a single-A rating.

A top-rated insurer can boost the credit rating of a municipal bond and let a government borrow money at a lower interest rate. Now, though, municipalities are starting to steer clear of these insurers and are going it alone on their own credit rating.

According to a report filed by CNN Money, $20 billion in municipal bonds were issued last month, but only $5.4 billion, or 27 percent, were insured. In February 2007, more than half of the $39 billion issued was covered by insurers. The city of Virginia Beach, Va., went ahead this month with a $90 million issue based solely on its credit rating and without a bond insurer.

Chances are that even more municipalities will consider going to market by themselves and using their own bond rating at sale time instead of relying on one held by an insurer. Havoc can result in a bond's pricing if the security's insurer is downgraded, even when the rating held by the municipality remains stable and exceeds the insurer's.

The city can speak to that highly unusual situation.

The bonds the city issued in 1993 were insured by the Financial Guaranty Insurance Co. Back then FGIC held a triple-A rating, but today the firm has been downgraded to single-A. The 1993 bonds have a variable interest rate and the lower FGIC rating is affecting the price.

"One of the things that I think is unprecedented that is occurring in the municipal markets is the city's double-A bond (rating) has been disregarded, and the bonds are actually trading on the basis of the insurer, who is rated A even though the revenue bonds are rated AA. There are all kinds of market inefficiencies and things that haven't been seen before occurring right now," said Scott Burher, the city's chief financial officer.

"One more downgrade and those bonds will turn into a default," said DDA Treasurer Jana Wallace, also a member of the city's fiscal services department. "We're paying close to 10 percent."

A default wouldn't be based on non-payment but would break an insurance pledge the city has with bondholders.

"This is something that no one has ever been through before," said Wallace, while adding that the DDA fixed-rate bonds aren't at risk for default.

But Burher said the city's exposure in this less stable market is very low when compared to other issuers that have 30 percent or more of their bonds trading at variable rates.

"Downgrades don't affect the city because the city used them to enhance the credit rating to issue debt on a fixed-rate basis. The people who are harmed by those downgrades are the people who bought the bonds on the secondary market. The city's interest rates were fixed when they issued all of our other debt. The only variable rate the city ever issued was this 1993 water bond," he said.

"So we have very little exposure. But we were harmed on that one deal with the downgrade."

An insurer's drop from a triple-A rating to a single-A can raise a bond's yield by at least a half-point. And if a municipality is looking to get tens of millions of dollars in revenue from an issue, a half-point hike in an interest rate that will be paid out over 30 years adds up to some serious money.

Burher said the market is currently oversaturated with variable-rate municipal bonds that governments are trying to get refunded. So many are out there that supply exceeds demand, and cities, counties and other units are being forced to offer higher interest rates to get the debts sold.

The fixed-rate market isn't as secure as it once was, either. Despite cuts to the bank rate by the Federal Reserve, which is concerned with containing inflation, long-term issuances like mortgages have gone up by three-quarters of a point in the past few months.

Burher said those rates have risen because the "long-end of the curve is very sensitive to inflationary concerns." The same is happening in the bond market as higher long-term yields are needed to draw buyers. Burher said no one wants to purchase a bond that they're upside-down on now, will be for 30 years, and can never sell without taking a loss.

Commissioners gave Burher the green light a few weeks ago to begin moving forward on the revenue bonds and the restructuring of the 1993 bond, which he said has been reacting in an unpredictable fashion with its weekly pricing resets. Wallace and DDA Counsel Dick Wendt are working with Burher on the project.

"We converted it to an alternative rate versus the bond rate and, as a result, we are very motivated to try to change the way the bond is pricing in the market. If we're able to do that, then there will be less pressure. We originally contemplated that we would do these bond issues in the fall," said Burher.

"But with the 1993 water bond pricing the way it has in the last few weeks, it caused us to think that it would be in everybody's best interest to potentially accelerate those bond issues so we can spread the costs and gain the efficiencies in doing the bonds all at once."

Burher said the city may issue the new revenue bonds without using an insurer, or it may use one that avoided the sub-prime mess, as Financial Security Assurance did. But Wallace said FSA wasn't interested in insuring the bonds and to get the insurer interested the city would have to pay a higher premium for coverage because FSA is getting more business now due to the current financial condition of other municipal insurers.

Wallace also said that the market prefers "natural" triple-A and double-A ratings over purchasing ratings from bond insurers.

The 1993 bond gave the city $46 million in revenue. It has an outstanding balance of $33 million that will be paid out over the next 12 years.

Bond Yields Rise From 2007

Current yield rates for 20- and 30-year tax-free municipal bonds are higher today than at the same time last year, regardless of the bond’s rating. Only the yields for 10-year bonds with a triple- or double-A rating have fallen slightly from last year.

Here are the average national rates for municipal bonds.

Maturity Rate

AAA Rated

Year Ago

AA Rated

Year Ago


Rated

Year Ago

10 Year

3.70

3.75

3.80

3.85

4.30

4.10

20 Year

4.60

4.00

4.85

4.15

5.00

4.30

30 Year

4.70

4.05

4.90

4.20

5.00

4.30

Source: FMSbonds.com, March 2008

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