After years of relatively fat times, cities and towns nationally are finding themselves in dire financial straits.
First the bad news: As tough as it’s been so far for a lot of towns, it will get much worse in the next two years.
Revenue from sales tax and income tax have already taken a hit, but the other shoe to drop - property tax - takes about 18 to 24 months to be felt, according to Mark Muro, director of policy at Brookings Institution’s Metropolitan Policy Program.
So, while the budget cuts so far may have been an “orderly retrenchment,” according to Muro, they will get much more “draconian” over the next two years, he said, as the inevitable shortfalls in property tax revenue start to wreak havoc with cities’ balance sheets.
In fact, Muro said the cuts over the next couple of years will be drastic enough that the role of government in our lives will be re-examined. In a recent speech he gave to the National League of Cities, he refers to this economic environment that cities face as the “new normal.”
Now the good news: You might think this all means the best advice you can give clients is to stay away from municipal bonds, but that is not true.
Clients, especially high-net-worth clients who are looking at inevitable tax increases in the coming years, can still find some benefit from munis. But they need to be very careful where they step.
While municipalities may be hurting, some of their bonds aren’t suffering as much due to several offsetting factors.
The first such factor comes from one of the primary lessons of value: scarcity. Just like the diamond-water paradox (for you economics lovers) or a Honus Wagner card (for you baseball fans), scarcity drives value. And the fact is, there aren’t that many municipal bond offerings out there.
This scarcity is partly due to the popularity of Build America Bonds, which are issued by municipalities to fund their capital projects. Indeed, roughly a third of the issues that would have been tax-exempt muni bonds over the past 10 months have instead been financed with taxable BABs.
These taxable bonds are typically bought by institutional investors like life insurance companies or pension funds. And if the BAB program is extended, as expected, they will continue to create a scarcity of tax-exempt munis.
Plus, the new muni issues that are coming out have very low rates attached to them, which is causing muni investors to seek out better opportunities in the secondary market, said Philip Villaluz, managing director of institutional sales and head of municipal strategy at Advisors Asset Management.
This will continue to characterize the market as many clients are looking at the very real prospect of higher taxes in the future, he said.
But even more important, on the good news front, is the segmentation in the muni market. Many munis have not been hurt because they are specifically issued to finance revenue-producing projects. Projects like toll roads, sewer projects or even some hospitals, have bond covenants that mandate they adjust fees, Villaluz said.
The muni market is in the midst of a massive tug-of- war with headline and perceived credit risks on one side versus investors’ seeking higher yield and tax-exempt income on the other. But with capital projects that produce revenue, and a shortage of traditional munis, your clients can still find themselves on the winning side.
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