Municipal Bonds 101 - A Quick Course

“It is essential that we raise the debt ceiling,” Thomas McLoughlin, Managing Director, UBS Wealth Management Research, told Westport Sunrise Rotary recently. 

This was at the core of the talk he delivered to the club and its guests – a quick, timely and topical overview of the municipal bond market.

U.S. Treasury securities are the global benchmark of a risk-free investment, he said. A failure to raise the ceiling will bring on a default that would destroy that standard and set off a series of global repercussions.

“If you liked September 2008, then you’re going to love August 2011,” he said.  

He noted that the ceiling has been raised 12 times in the last 10 years, then underscored its importance by saying if the ceiling is not raised, “the ramifications are too severe to contemplate.” 

McLoughlin also expressed concern about our $14.3 trillion of indebtedness, in itself substantial, but the “scarier perspective” is that our debt is 96 percent of United States' $14.7 trillion Gross Domestic Product.  

Reducing that figure, he said, must include regaining some of the “foregone revenues” the Internal Revenue Service code allows taxpayers. He cited the corporate deduction for health insurance ($137 billion) and the mortgage deduction ($88 billion) as two of the largest.

The municipal bond market is comprised of over $3 trillion of indebtedness issued by more than 50,000 U.S. state, county and municipal governments and government entities.  

Five years ago more than 55 percent of these bonds were “enhanced” by insurance purchased from companies with the highest credit rating, giving a bond the same rating as the insurer. This “wrap” made the market efficient because it gave buyers the knowledge that a default would be cured by the insurer.

Then markets imploded and depleted the lions' share of the insurers’ capital. By September 2008 it was impossible to value securities. Fast forward to today, only three percent of municipal bonds are insured. Consequently, the market has shrunk, investor risk has risen, and interest has focused on about 300 issues major issuers and made ratings more relevant.

He continued, addressing two challenges the municipal market faces today: unfunded pension liabilities and the cost to state governments of Medicaid. The pension shortage is estimated at between $1.2 trillion and $3.3 trillion – depending on assumptions such as life expectancy and rate of return and the method used to value the liability.  

He said that while only 20 percent of private sector businesses still offer defined benefit plans, 80 percent of the public sector continues to do so – though governments are beginning to make the change. He cited Utah as one state that now offers a hybrid plan combining the two. 

Connecticut, McLoughlin said, has no constitutional guarantee that all pension benefits will be paid. But municipalities must fulfill their bargaining units' contractual obligations. 

He added that “state spending on Medicaid is growing more rapidly than any other single component of state budgets and is increasing at a faster rate than the economy as a whole.” Medicaid is a means tested program that an observer noted, due to the continuing weak economy now provides coverage for about 20 percent of all Americans.

He also told the group that “the likelihood of comprehensive tax reform is fairly high.”

Simpson-Bowles focused attention, but typically the process takes at least 18 months to unfold. Substantive discussions are being held and UBS colleagues in Washington say “passage of such a measure must await the next presidential election."