Diversification, debt management key for cities in muni bond market

By KATE COIL

TT&C Assistant Editor

As Tennessee municipalities look for ways to finance capital projects and infrastructure amid unprecedented growth, changes to investment markets, federal monetary policy, and a new chair of the Federal Reserve are impacting the municipal bond market.

With state and federal budgets tightening, many cities are considering bonds and other funding sources for necessary projects. In a discussion moderated by Tennessee Municipal Bond Fund President and CEO Wade Morrell, Tennessee Treasurer David Lillard, FirstBank President and CEO Chris Holmes, and TCRS Director of Fixed Income Markus Klar gave insights into the future of local government finance during TML’s Legislative Conference at the DoubleTree Hotel in Nashville.

Lillard said debt can be a useful tool for municipalities – as long as they plan for debt service and borrow wisely. 

“We are in a place where we have never been before as a nation, where we have debt that is about 100% of our gross domestic product,” he said. “We have other issues going on as well, such as the Fed, that affect rates and the outlook for borrowing. What I’ve learned over the years is to take a very circumspect view about what you should use debt for and what you shouldn’t. Take every opportunity to pre-fund obligations on the way. You need to think from a long-term standpoint of planning and implementing a debt policy, what your issuance level is, and what the maximum occurable debt level is that you’re incurring.”

Lillard said moves by the White House to have more control over the Federal Reserve would impact the municipal bond market. 

“The Fed’s 10-year treasury bond rate is hovering at right around 4%, though it has been higher in recent times,” Lillard said. “As we all know, the president has announced that his idea is that rates should be a lot lower. What that means and where it’s going is another question. That is dependent on the economic conditions of the world at large. While rates going down may seem good from a numbers standpoint, it does encourage a lot of borrowers to go ahead and pull a trigger to issue debt. Rates are going to move and be priced on municipal market data, which is going to change and probably be going down.”

Holmes said he felt independence for the Fed is important for both the national and world economy.

“When the Fed is moving rates, it’s moving short-term rates,” he said. “Its control is really over the short-term and while the short-term rates have come down some, we have still seen long-term rates go up. While the Fed does have a huge influence, the bond market sometimes has a mind of its own. It may move in a different direction, and we’ve seen that recently.”

At present, Holmes said there is still a good demand for municipal debt by banks.

“Credit quality remains stable and has remained stable for some time, which has kept demand strong,” he said. “As long as a good supply continues to come, there will be a good demand. In the very near term, there can always be things that are way beyond our control, like a war in the Middle East. Things still remain good from a macro standpoint.”

However, Holmes said there are certain issues lenders are starting to factor in before taking on municipal debt, such as cost shifts on the federal levels, healthcare reimbursements, education, and susceptibility to natural disasters and severe weather. As a buyer and underwriter of municipal debt, Holmes said he often sits on both sides of the table when it comes to analyzing municipal debt. 

With banks continuing to merge and consolidate, Holmes said municipalities can often see branch banks close or even move out of a service area due to decreased demand for services. While that may have an impact, he said he still thinks there are opportunities for cities to obtain financing.

“Tennessee is blessed to be on firm financial footing,” he said. “There are states that if they were corporations they would have been bankrupted already. The fact that we have the lowest debt per capita of all 50 states and that we continue to run surpluses at the state level creates goodwill that provides good opportunities for municipal debt. I can tell you we will not buy debt from municipalities in the state of Illinois – even if that city is on solid footing - because they don’t have that anchor. If you take care of business, I think you have plenty of options.” 

As a community bank, Holmes said FirstBank has a different approach than some of the larger, corporate banks that are less interested in financing local projects.

“It is important to us to be important financiers in communities,” Holmes said. “In addition to that, we think [municipalities are] frankly good business. I would say to municipalities that the deposit side of your balance sheet is more powerful than perhaps you realize. You should be earning quite well on those deposits, which should help in the greater scheme of things. Deposits have become a more competitive business.”

Klar said there is a lot of demand for bonds, and Tennessee is an attractive place to invest because it is fiscally conservative, well-managed, and diversified.

“Right now, the outlook is good, but we will see what happens with the new conflict that has broken out [in the Middle East],” Klar said. “There are a couple of dynamics I am monitoring, and the investor base has monitoring. There are dynamics that have been in place for a long time that are now changing into something that could be less favorable. One thing that increasingly more people are paying attention to is the change in demographics in the U.S. With immigration basically at zero, the Congressional Budget Office said the population will only increase by 4.5% over the next 30 years. That will have an impact on home price appreciation, revenue from property taxes, and revenue for sales taxes as there are fewer people in society who can spend money.”

Klar said another concern is a “lack of fiscal discipline in Washington” that may cause financial problems down the line.

“We are spending money like a drunken sailor, even during good times,” he said. “In the past, money was being spent to fix urgent problems so they didn’t drag down the entire economy. Now we are spending money to make the good times better. We are looking at a deficit of close to $2 trillion. No matter how well the economy is doing, this money is proactively spent this year, next year, and the year after that. This works until it doesn’t, and once it no longer works, we have a gigantic mess on our hands.”

The third major change Klar said investors are monitoring is the change in relationships between the U.S. and its allies.

“Two months ago at Davos, the quotes from Canada that the U.S. is no longer a trustworthy ally have been echoed by France and Germany,” Klar said. “The world is slowly trying to diversify away from the U.S. This is a longer-term problem, but we are still monitoring it. Europe is one of the top investors of the U.S., so if they diversify away or try to become more independent, that could be a problem here.”

However, Klar said he feels the most immediate threat to the bond market is the impact of AI.

“AI will take jobs away,” Klar said. “Previously, new technologies have always taken jobs away and created new jobs. Both of the CEOS of the main AI companies are reminding us that AI will kill jobs. That is their marketing pitch. Until two weeks ago, the market strangely ignored that, but we have seen some recent progress in AI firms, and now the market has become scared. We are seeing damage in software and technology stocks that has the risk of spreading. If the market becomes more concerned about that, there could be more problems.”

To meet these challenges, Klar said cities should diversify their debt portfolios. He said investing is like a chess game and by diversifying, officials can ensure they have more pieces on the board. He also said officials might want to consider making investments earlier rather than later, as forecasting the future is difficult.

Fortunately, Klar said Tennessee has a good reputation on the financial market with strong growth, diverse investments, and good management. Holmes agreed that Tennessee’s history of financial conservatism and debt management makes it more investor-friendly.

Lillard said Tennessee is one of only 13 states with an AAA bond rating, and part of that rating is based on what local governments have achieved. Lillard said measures to cap property taxes could impact the ability of cities to pay off debt, and it is incumbent on city leaders to aggressively to manage their financial portfolios.

“Taxpayers are frustrated,” Lillard said. “They are looking at inflation at the grocery store, the pump, and everywhere else. There are other problems going on that create an environment where people are looking at limiting the government’s ability to raise revenue. We have to redouble our efforts to make sure we provide even better value to our taxpayers so there is less pressure to do these things.”