Friday, January 14, 2011

Economic crisis of cities and state's: Two pictures are worth a thousand words

That is if the pictures are of the Treasury yield curve and the Aaa municipal bond yield curve

The budgetary crises for state and local governments is discussed often in the media, along with possible solutions including drastic spending cuts, reduction of services (including some essential services) offered and potential tax increases of various types.

The need stems from lower tax revenues coupled with out of control spending.

The problem is not universal across all towns, cities and states, but it is close.

Remember that the principal and interest payments of a general obligation bond issued by a town, city or state government are secured by the full faith and credit or taxing power of the entity issuing them. This means they can raise taxes to whatever level is necessary to pay back these debts.

Remember also that although this power to raise taxes is unlimited, in practice it is not because at a certain level people will balk and move away, or even worse for the powers that be, vote them out of office.

The interest paid on a tax-exempt municipal bond is free from federal taxes and often state and local taxes if the buyer of the bond buys the debt from an issuer in their own state.

As a result, the yields of Aaa rated municipal bond or note have historically been below the yields of a similar maturity treasury bond or note (there is a calculation known as taxable equivalent yield).

The quality of similar rated municipals will vary, but for this discussion let's assume all Aaa munis GOs are the same. The yield curve below illustrates the fact that the return demanded by investors for munis is the same, or in some cases greater than those of the same maturity Treasury.

This situation is atypical (although it has occurred in the past), but it indicates that the buyers of this debt are not happy with the management of these cities and states or as confident as in the past that these bonds truly represent Aaa quality.

The old adage of higher risk, higher return demanded will never change.

The discussion could be longer. We could examine for example the proposed $9 billion State of Illinois general obligation bond, a full $6 billion of which would be used just to pay the overdue bills of the state.

But for now, two pictures, 1000 words!

US Treasury
Yield Curve

S&P AAA Municipal
Composite Yields

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