Bonds

Debt ceiling resolved for now, but risks to muni market remain

Despite a relatively drama-free resolution to the nation’s debt limit debate, risks remain for state and local governments, chief among them cuts in federal spending, higher borrowing costs and skittish municipal market buyers.

That was the message from panelists weighing in Thursday during a webinar hosted by the Volcker Alliance on the implications of the recent debt ceiling deal.

The risks for the muni market are both structural and political, experts said.

The debt ceiling debate highlighted problems tied to an increasingly concentrated buyer base in a muni market dominated by “fickle” retail buyers who are unnerved by dysfunctional Washington politics, said Vikram Rai, the head of Citi’s municipal strategy group.

“Retail is watching the same news we are … so state and local governments will be exposed to the shifting sentiments of retail investors,” Rai said. “Going forward I remain worried we are not going in the right direction and issuers and investors will have to worry about volatility. And if we go into a recession, that’s the time when issuers need access to capital markets the most and need funding at attractive rates, but the concentrated buyer base is very fickle and that will put pressure on state and local governments.”

Muni issuers should get accustomed to higher interest rates, said Matt Fabian, partner at Municipal Market Analytics.

“We have a thin pool of lenders at current prices and the thinness means that in order to get through any potential hiccups in the flow of capital will take higher rates – that’s probably the future,” Fabian said. Higher borrowing costs will be coupled with an increased need to borrow to fund capital projects tied to climate change, he added. “So that puts pressure on states and local governments for how they’re paying for their debt and their budgets.”

House Republicans and the White House hammered out the debt deal with relative ease, but political stakes this week suddenly shifted and got higher, said Marcia Howard, executive director of Federal Funds Information for States.

While the debt deal set spending caps at fiscal 2023 levels, House Republicans in the last week have said they would instead seek to appropriate at lower fiscal 2022 levels.

“While we believe the original legislation paved the way for a very smooth process … now we’ve come to believe that recent developments have unraveled that and the months ahead are going to be very perilous, complicated and politically fraught,” Howard said. The debt deal included incentives to pass timely appropriation bills, but recent political moves have signaled a shutdown may be ahead, she warned.

Assuming future cutbacks in federal funds to states, Rai said he’s worried that high-tax states that are already seeing outmigration, like Illinois, New York and California, could be forced to raise taxes even more, driving the exodus higher.

“If these states receive less in grants going forward, how will they make up for it? By raising taxes. But these are already high-tax states,” Rai said. “That’s one of my worries.”

On the flip side, Fabian noted that high-tax states tend to have residents more amenable to tax increases, and tend to be “better at raising taxes” than low-tax states, which face a strong anti-tax sentiments.

“California can get its people to approve nearly anything,” Fabian said.

Beyond state and local governments, one sector that’s suffering now, and likely to suffer more in the future from federal cuts, is not-for-profit health care.

“This [debt ceiling] drama is going to play out again in 2025,” Rai said. “The next fight unfortunately is going to be about health care,” where programs like Medicaid, Medicare and the Children’s Health Insurance Program make up about 25% of all spending, he said. “These big-ticket items are very important and the U.S. healthcare system is eroding.”

So far this year, more than $9 billion of hospital debt has disclosed “some kind of technical default,” according to Fabian. That’s “far and away” more than any even full-year total in the past, he said.

 ”2023 is nearly at the level of the great financial crisis for the dollar amount of borrowers disclosing financial problems,” he said. “It’s mostly a message of pervasive and continuing trouble” in the not-for-profit health care space.

Investors are taking note, Fabian said, and it’s becoming more difficult for some hospitals to borrow money.

Meanwhile, markets are set to be flooded with Treasuries as the government refills its general account after spending it down to nearly zero, while at the same time the Federal Reserve continues to unload roughly $60 billion a month, said Torsten Slok, partner and chief economist with Apollo Global Management.

“The supply of Treasuries over the next several months is going to be very, very significant, at levels we’ve not seen before in U.S. history,” Stok said, adding that it will “test the limits” of whether the U.S. can remain the world’s reserve currency.

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