Ultra-low interest rates, zero and even negative interest rates are becoming the norm in investment-grade credit. This global fire sale on borrowed funds presents opportunities and challenges alike for state and local financial managers and for public employee pension systems.
In late August 2019, over $15 trillion of debt was carrying negative yields. This included the entire German yield curve, with 30-year “bunds” returning -0.13 percent annually. Ten-year bonds with no coupon were yielding -0.67 percent, meaning that the government could sell a new bond for €10,695 in August 2019 and repay €10,000 in August 2029 without making any interest payments.
Sub-sovereign governments are also seeing negative yields. German länder (states) such as Baden-Wuerttemberg, Berlin, and Hamburg all have debt trading at yields below zero, as does the Zurich Canton in Switzerland.
And negative yields aren’t only available to European governments. The Canadian province of Ontario, which carries a high debt burden relative to US states, issues bonds in multiple currencies including Euros and Swiss Francs. Several of these issues recently traded at negative yields, as low as -0.44 percent for bonds maturing in 2024. Meanwhile, Swiss Franc denominated bonds issued by the Australian state of Queensland recently yielded -0.11 percent.
US Dollar-denominated bonds maintain positive yields, but interest rates have been declining during much of 2019 and could fall much further if the economy dips into a recession. In this event, the Federal Reserve would likely create new reserves and investors would sell equities, increasing the amount of money seeking fixed income securities.
In August, AAA-rated Maryland issued 10-year bonds yielding 1.26 percent. Although the tax-exempt bonds carry coupons totaling 5 percent of face value per year, they sold at a large premium: $10,000 of bonds at face value were priced at $13,478.80. Principal depreciation offsets semi-annual coupon payments to produce the low yield. For bonds maturing in 10 years or more, 5 percent coupons are common regardless of market interest rates. Bonds maturing in more than 10 years are typically “callable” (i.e., redeemable at the option of the government issuer) on the tenth anniversary of issuance.
Tim Schaefer, California’s deputy state treasurer, told me that 5 percent bonds callable after 10 years are a market convention that investors have come to expect.
Experts have expressed skepticism about the possibility of negative yields reaching the US municipal market. Bank of America analysts cited by Bloomberg, for example, argue that municipal bonds are attractive to investors because they offer tax-exempt interest. Municipal bonds with zero or negative yields would no longer have this benefit.
That analysis assumes the municipal bond market will remain separate from markets for other highly rated debt. Currently, foreign investors hold $100 million of the $3.9 billion of municipal bonds outstanding despite their likely inability to take advantage of the tax exemption. As rates fall, the value of the municipal tax exemption declines. Assuming a 40 percent combined federal/local tax rate, the taxable-equivalent yield on a 5 percent municipal bond is 8.33 percent, but a tax-free yield of 0.5 percent has a taxable equivalent of just 0.83 percent. A low-interest environment might draw more overseas money to US municipals as the effect of the tax exemption shrinks.
Whether or not municipal borrowing rates enter negative territory, they are likely to remain at or near historical lows for an extended period. This environment will create more opportunities to refinance (or “refund”) municipal bonds at lower rates, saving taxpayers money. The 2017 Tax Cuts and Jobs Act narrowed the window for such refinancing activity because it makes interest on advance refunding bonds taxable. Now, issuers can only qualify for tax-exempt refinancing if the bonds to be replaced are maturing or callable within 90 days. But as interest rates fall towards zero, advance refunding with taxable bonds may begin to make sense.
Very low interest rates also make state and local infrastructure borrowing more affordable. But if the economy dips into a recession, governments may be reluctant to take on debt. In California, for example, most government revenue is derived from highly cyclical income and capital gains taxes. The level of new bond issuance during the depth of a recession would depend on a belief that these revenue sources would recover by the time principal must be repaid from the general fund.
Low rates may also encourage state and local governments to issue more pension obligation bonds. Earlier this year, Chowchilla, a small California city, issued pension obligation bonds (POBs) with yields ranging from 2.94 percent for one-year maturity to 4.81 percent for a 27-year maturity. A larger government with a higher credit rating would likely achieve significantly lower yields.
If a state, major county or city could issue POBs with average yields of 3 percent or even less, such an issuance may appear attractive. With assumed rates of return hovering around 7 percent, POB issuance might seem to be an easy way to profit. But that 7 percent is not guaranteed: much lower returns are possible, especially during a recession.
Further, a regime of ultra-low, and possibly negative, interest rates strengthen the case for making downward adjustments to pension system return assumptions. Fixed income securities have long been a staple of pension portfolios, and their lower yields will weigh down overall portfolio returns.
An offsetting benefit of lower yields may be coming to an end. As interest rates have declined since the early 1980s, the prices of fixed income securities have risen. These capital gains became part of pension system returns, offsetting the impact of lower rates. But it would now seem that fixed income yields are reaching an absolute bottom from which further declines are impossible, foreclosing opportunities for further capital gains.
Given political pressures to maintain monetary stimulus at least through the 2020 election, ultra-low interest rates may be with us for an extended time. Whether major US states can join their German, Swiss, Canadian and Australian counterparts in achieving negative yields remains to be seen, but, regardless of whether state and local interest rates fall below zero, we are entering uncharted waters. Hopefully, governments seeking to take advantage of this new normal will find better financing deals for their taxpayers without taking on excessive risk.