Muni Finance and the Federal Fiscal Food Fight (Opinion)

Deficit financing has caught up with Uncle Sam, as federal outlays for interest payments have surged to record levels and the nation’s annual budget deficit is on track to double in this fiscal year. That’s just for starters: To dampen inflation, the Federal Reserve has hiked short-term interest rates and keeps jettisoning U.S. bonds, not buying them as it had been. Meanwhile, key foreign buyers including China have recently exited the Treasury market, also driving yields a bit higher.

Those federal interest expenses appear doomed to escalate yet higher in the next year or two as older, cheaper debt rolls off the books while forthcoming budgets remain locked in deficits and ambitious prior infrastructure appropriations are spent. Beyond that, compound interest will be America’s gnarlier enemy unless budget discipline is re-established on Capitol Hill. The Fitch rating service has downgraded Treasury debt, citing the partisan congressional dysfunctionality fueling this fiscal food fight.

So far, the indirect impact on the municipal bond market of these tectonic macro shifts is measured in fractions of a percentage point, so it’s hardly the end of the world. In California earthquake-speak, it’s a tremor, not a Big One.

Meanwhile, the impact on state and local operating budgets today is arguably net-positive for most. But fiscal hawks and critics of Modern Monetary Theory are crowing that a dreary hangover of elevated and more costly interest rates seems to be here to stay — at least until the next recession, when the central bank presumably will have no choice but to once again cut rates and investors flee stocks to pile into the safety of government bonds. Bond market math is indeed a dismal science.

With nasty partisan political budget battling likely to resume in the coming month, the issue of deficit financing will return to center stage. Although most pundits expect that Congress will ultimately approve various appropriations to avert a government shutdown, next year’s budget line items for intergovernmental aid will once again be on some budget hawks’ chopping block, and the perennial sparring over tax-exempt bond rules is always a collateral damage threat to the muni bond market.

On the rosier side of this paradox, public-sector cash managers are now cheerfully gleaning short-term yields on their investments that exceed the CPI inflation rate. That produces a clearly positive “real” rate of return (net of inflation) for the first time in a decade. Public-sector cash invested tax-free today will likely buy more goods and most services next year, for a pleasant change. (Escalating health insurance premiums are a maddening exception.)

Even public financiers who unwisely invested too far into the future at puny rates during the pandemic have now washed away their mistakes and will be back in the black with their prospective portfolio values in coming months. Time was their ultimate cover-up.

Short-term money market yields are now expected to hover above 5 percent until the Federal Reserve sees inflation consistently drifting down closer to its 2 percent target, so cash managers are likely to make positive contributions to operating budgets for some time to come. Happily for budgeters, the rate outlook for the coming year looks pretty stable, so revenue estimation will generally be easier and hopefully more accurate with less guesswork.

Muni Bond Metrics

In the municipal bond market, the recent uptick in Treasury bond yields, especially in the Treasury Inflation Protected Securities market, has impacted tax-exempt borrowers. Typically muni bonds trade off the Treasury bond interest rate structure with a yield advantage for their federal tax exemption. But if traditional buyers of T-bonds are skittish about U.S. debt at a time when the Fed is trimming its bond holdings to rein in the money supply to combat inflation, the market pressure on tax-exempt issuers will remain adverse, with bond issuers on the hook for fractionally higher yields.

So far the impact of these yield shifts in the long-bond market have been modest and nobody has really been crowded out by federal deficits, but the Fitch ratings downgrade should be a wake-up call to state and local financiers.

In theory, the cost of high-quality muni debt should be less than the inflation rate, in light of the 30 percent tax-exemption advantage that many wealthy investors glean from them. But in today’s market, most states and localities must increasingly pay the price of near-record real interest rates in the U.S. Treasury market. Triple A issuers of 20-year serial muni bonds can slightly undercut today’s latest CPI inflation rate, but even they will pay a real interest cost if price inflation does eventually normalize to lower levels. Meanwhile, most muni issuers — almost everybody with lower ratings — are already paying a cost above inflation, albeit less than comparably rated corporate borrowers.

Today’s U.S. Treasury market inverted yield curve, with especially attractive short-term T-bill yields, is also an open invitation to “abusive” — and therefore profitable — reinvestment of lower-cost tax-exempt borrowings in higher-yielding Treasuries. This recent market development is certain to draw the ire of congressional and IRS tax policy staffers. Beware the arbitrage watchdogs who are waiting to pounce if too many public-sector CFOs get too cute by turning a quick profit on untaxed borrowings.

The ultimate longer-term federal fiscal impact on muni finance could be less interest rate-driven and more political. It’s no secret that congressional tax committees are always looking for ways to trim the issuance of tax-exempt debt, which the Congressional Budget Office scores as a “tax expenditure” in its budget forecasts. With Congress divided politically and a muni-friendly White House for now, I don’t fear major erosion of the tax exemption in this congressional term. But when the 2017 federal tax cuts expire after 2025, muni mavens need to remain en garde, especially for new restrictions on conduit financing, advance refundings and investment arbitrage.

Bolstered Pension Funds?

One other aspect of higher real interest rates is the longer-term benefit for public pension funds if bonds can continue to consistently deliver a material risk-free real return on investment.

Once (and if) stock valuations eventually adjust to sustained positive real interest rates, the assumed positive spread between public pension fund portfolios’ investment portfolio returns and their benefits-cost inflation could ultimately bolster actuarial valuations and relieve pressure on future payroll contribution rates.

That’s provided that subsequent federal budget deficits do not worsen beyond a tipping point and the Federal Reserve doesn’t persistently monetize escalating compound interest costs in the next decade. The latter scenario would reignite the pension funds’ inflation anathema and drive payroll costs skyward.

So my word to the wise for pension trustees and public employers is that although today’s real interest rates could someday become a long-term boon to pension payroll costs, that scenario requires future federal fiscal discipline that so far eludes Capitol Hill. Don’t count those chickens before they’re hatched.

As with global warming and climate change, the impact of federal deficit finance will be gradual but increasingly evident to state and local leaders. Like the world’s glaciers, the ice keeps getting thinner as political frictions heat up. So it’s wise to be ready for fiscally foul weather coming from Washington.