'Mispriced' munis a big hit overseas

Illinois capital-markets director John Sinsheimer and Citigroup Inc. bankers took a globe-girdling trip from the U.K. to China in June to persuade investors that the state's $900 million of Build America Bonds were a bargain. The seven-country visit worked. The state sold one-fifth of the federally subsidized securities abroad the next month, tapping investors who are the fastest-growing source of borrowed cash for U.S. municipalities. Illinois, with the lowest credit rating of any state from Moody's Investors Service, dangled yields higher than Mexico, which defaulted on debt in 1982, and Portugal, which costs more to insure against missed payments. “U.S. states are among the cheapest sovereign credits in the world,” said Patrick Brett, a Citigroup banker who marketed the Illinois securities overseas. “You're actually picking up a good amount of spread for arguably better credits relative to equivalently rated corporates and sovereigns.” International ownership of U.S. municipal bonds jumped 37 percent in the first half of the year from the end of 2009 to $83 billion, a Sept. 17 Federal Reserve report shows. Spurring the growth are Build America Bonds, created by President Barack Obama's economic stimulus program to finance public-works projects. More than $140 billion of the debt has been sold in the 17-month-old market. About a quarter may have been bought overseas through June, said Matt Fabian, an analyst with Concord, Massachusetts-based Municipal Market Advisors Inc. “The more types of investors you have, the better the overall market,” said Fabian, based in Westport, Connecticut. New York Sale New York City Comptroller John Liu is following Sinsheimer overseas today to sell municipal debt, according to the Wall Street Journal. The nation's most populous city is selling $500 million in tax-exempt debt tomorrow and $800 million in taxable securities the next day. Cathy Hanson, a spokeswoman for Liu, didn't respond immediately to an e-mail requesting comment. To make it cheaper for localities to borrow, the Treasury pays 35 percent of the interest cost of Build Americas, whose 30-year yields were about 1.4 percentage points higher than top- rated tax-exempt bonds yesterday, according to Wells Fargo & Co. and Municipal Market Advisors indexes. Build America interest payments are subject to federal taxes, unlike traditional municipals, whose tax-exempt yields aren't a lure for investors abroad. Selling Build Americas overseas has become typical since the first issue in April 2009, said Brian Mayhew, chief financial officer of the Bay Area Toll Authority in Oakland, California. His agency sold $2.8 billion of the debt in 2009 and 2010 for a new bridge across San Francisco Bay, with about $130 million going internationally, he said. Part of Plan “Every marketing plan included discussing things between Asian and European investors,” Mayhew said of his sales. Drawing overseas buyers are yields pushed up by concern about U.S. state budget deficits and pension-fund shortfalls spawned by the recent recession. While no state has defaulted since the Great Depression, Build America yields exceed those of countries with worse financial legacies. A taxable California bond maturing in 2040 traded yesterday to yield 6.9 percent. That was 1.72 percentage points more than similar bonds from Mexico, according to data compiled by Bloomberg. Portugal, whose long-term credit rating was cut in April by Standard & Poor's, yielded 6.2 percent yesterday on bonds due in 2037, 69 points less than California. A basis point is 0.01 percentage point. Mispricing Municipal Securities “The market continues to misprice municipals,” said Gary Pollack, who helps oversee $12 billion as a managing director of fixed income in New York for the wealth-management unit of Deutsche Bank AG, Germany's biggest bank. The Frankfurt-based company has bought Build America Bonds for overseas individuals and institutions, he said. “It's a high yield in a new asset class that offers great diversification,” said Pollack, who wouldn't say how much he bought for clients. UBI Pramerica SGR SpA, a Milan-based fund manager, was among buyers of 40-year Build Americas sold by the Bay Area Toll Authority in 2009, according to Bloomberg data. Skandia Global Funds Plc, a unit of London-based Old Mutual Plc, bought similar bonds from the Los Angeles Unified School District, the data show. The Julius Baer Multibond-Dollar Fund in Luxembourg purchased New York Metropolitan Transportation Authority debt. Emilio Franco, chief investment officer at UBI Pramerica, didn't return messages requesting comment. Skandia spokesman John Morgan said the fund that holds the bonds is run by Pacific Investment Management Co. Paul McCulley, a managing director at Newport Beach, California-based Pimco, didn't respond to requests for comment. Lynn Chen and Donald Quigley in New York, listed as managers of the Julius Baer fund, didn't respond. Cash Influx The influx of overseas cash, which is also buying U.S. Treasuries and supporting a $1.3 trillion federal budget deficit, is benefitting all state and local government debt. An index of 10-year AAA tax-exempt bond yields fell to 2.6 percent on Aug. 25, the lowest since the Municipal Market Advisors gauge began in January 2001. The average Build America yield was 5.5 percent yesterday, 1.8 percentage points more than 30-year Treasuries. In July, when Illinois sold its $900 million issue, the difference reached 2.1 percentage points. “They've been a good investment and they have very high coupons,” Municipal Market Advisors' Fabian said at the time of the Fed's report. “As an investor, what's not to like?” Illinois turned overseas amid financial strains at home. With California, it has the lowest credit rating of any state from Moody's, which put $25 billion of general-obligation bonds on negative outlook on Sept. 23. That indicates Moody's may again cut the state's A1 rating, the fifth-highest grade, after a one-level reduction June 4. Widening Deficit The state's budget deficit almost tripled in 2009 to $7.7 billion, Moody's said. Its pension fund had assets to cover just 50.6 percent of promised benefits last year, the lowest so- called funded ratio of any state in data compiled by Bloomberg. Going abroad saved Illinois about $30 million because of appetite for its debt there, said Sinsheimer, the capital- markets director, based on where final yields were set compared with initial expectations. The state paid a top yield of 7.35 percent on the 25-year debt in the July sale, more than the 20- year yield of Peru, which didn't exceed 7.1 percent in the month. “There was a feeling that the Build America Bond product was particularly of interest overseas,” said Sinsheimer. He wouldn't identify any buyers. Marketing Drawbacks The international market has drawbacks, said Mayhew at the Bay Area Toll Authority. Overseas investors unfamiliar with municipal debt were rattled by speculation this year that plunging state and local tax collections in the longest recession since the 1930s would trigger defaults, he said. “The taxable buyer was very spooked at the time,” said Mayhew. Whether overseas demand continues depends on the U.S. Senate, where efforts to keep the Build America program alive after its scheduled expiration in December have stalled amid concern about costs. The Treasury doesn't collect taxes on bond income earned abroad, adding expense to a program that's set to pay out $36 billion of subsidies in the 10 years from its 2009 creation, according to the Congressional Budget Office. Some international investors have lingered on the sidelines while the program's fate is debated, said Brian Wynne, head of the municipal underwriting syndicate for Morgan Stanley in New York. Meanwhile, Morgan Stanley put a member of its municipal underwriting team in London to reach buyers abroad, he said. “We think it has huge potential,” Wynne said.