Growing federal debt has negative knock-on effects for munis

Bonds

Municipal analysts are concerned the growing federal government debt may lead to challenges for municipal finances in the near-, medium- and long-term.

The increasing federal debt may force states and local governments to pay higher rates on their bonds.

“Since some municipal investors may also choose Treasuries given their very low risk, the greater supply of Treasuries may make it harder for states, counties, and cities to sell bonds, obliging them to offer higher yields,” said Cato Institute State and Federalism Policy Analyst Marc Joffe. He said this problem will gradually increase over time.

Roosevelt &

Municipal Market Analytics, Inc. Chief Credit Officer and Managing Director Lisa Washburn agreed over the long-term rising federal interest rates would force states and localities to pay more when issuing bonds.

“The current federal debt level, and especially the pace at which it is now growing, is a problem,” said Hilltop Securities Director of Municipal Strategy and Credit Tom Kozlik. “This problem increases exponentially and the potential solutions grow more difficult to institute every year they are ignored.”

As debt rises and the amount needed for debt service grow, the U.S. could have less money to provide states and cities. “Lower federal spending for some credits will have a minimal impact but for others it could result in rating downgrades,” Kozlik said.

The growing federal debt level may pressure the government to retract or reduce the tax-exemption for munis to generate revenue, he added.

And economic or weather-related crises, when states and local governments are often more dependent on the federal government, “could challenge the liquidity and/or longer-term finances of affected states and local governments,” Washburn said, if less response money is available.

The federal government’s increase in debt will put the federal government itself in a tougher position over time, said John Hallacy, president of John Hallacy Consulting. “Chances are that yields on new federal debt will be pushed higher in order to be placed successfully [and] that in turn will further aggravate the budget over time.”

In August Fitch Ratings downgraded the United States sovereign debt to AA-plus from AAA. In November Moody’s Ratings put a negative outlook on its Aaa rating of the debt. In March the Congressional Budget Office released a 30-year outlook that predicted federal debt would reach 107% of U.S. gross domestic product by 2029, exceeding the previous record of 106% set during World War II.

“There appears to be little incentive to arrest the growth of the federal debt profile which means the problem will intensify,” Hallacy said.

If debt service continues to rise as the CBO is projecting, other funding options will be squeezed, analysts said.

It is widely believed that “servicing the debt will crowd out other important governmental priorities for spending,” Hallacy said.

As debt service grows as a percent of federal spending, “it is more likely that some portion of the problem gets downstreamed to states and local governments either through reduced federal transfer payments … or unfunded mandates,” Washburn said.

CreditSights Senior Municipal Strategist Pat Luby agreed, saying, “Unexpected or unbudgeted costs, such as natural disaster aid, could be treated differently in the future than they have been in the past. Federal spending on state and locally built or managed infrastructure could be imperiled, but in some cases, that could mean that projects get financed by user fees and revenue bonds, rather than waiting for federal aid.”

State and local credits with higher dependence on federal spending will be most hurt, said Susannah Page, manager of research and senior vice president at Roosevelt & Cross, with some examples being states with high percentage of Medicaid support, areas getting large amounts of federal funding for infrastructure projects or military bases. A U.S. credit downturn “would hit localities at higher risk of climate generated damage — from flooding, wildfires, earthquakes — which depend on Federal Emergency Management Agency funding for rebuilding.”

Luby said the growing debt pressure on the federal government means low-lying areas are less likely to get FEMA money. “If the economics of post-disaster rebuilding are changed, that could have long term implications for those economies.”

John Mousseau, chief executive officer and director of fixed income at Cumberland Advisors, said the current historically low muni to Treasury ratios may partly reflect growing credit skepticism of Treasuries. He noted that credit default swaps on U.S. debt have grown by about 50 basis points in the last year or so. “That is real people putting up real money and so that is people voting saying, ‘hey, we see U.S. debt as more risky than we did before.'”

Analysts disagreed on the likely impact of November’s federal elections on the federal debt. “I think that the election results for the White House and both chambers of Congress will very much determine whether the recent spending and borrowing trends continue or if there will be some changes,” Luby said.

However, Kozlik said, “there are political incentives to avoid the issue at best and to add to the debt if possible” and after November’s election it was “very unlikely that change occurs.”

At a March Municipal Analysts Group of New York event, Moody’s Chief Credit Officer and Head of Global Credit Strategy and Research Atsi Sheth said Moody’s has historically found elections make little difference to overall sovereign rating quality but that they can have rapid and significant impacts on sector rating qualities.

From the fourth quarter of 2005 to the first quarter of this year, adjusting for inflation U.S. municipal debt has decreased 16% but federal marketable debt held by the public has increased 312%, according to figures provided by Luby.

Observers say the federal government is likely to grow. “Absent any material fiscal policy changes, we expect the government to run large fiscal deficits of around 6% of GDP over the near term to about 8.5% by 2034, which would drive the debt burden to 129% of GDP by 2034 from 97% in 2023,” Sheth said.

In the CBO March report, it also predicted the federal debt to GDP ratio would climb from 107% in 2029 to 166% in 2054. This assumes that tax cuts passed in 2017 and scheduled to lapse in 2025 are allowed to fully lapse.

In the next 30 years the increasing debt will be a “significant risk” to the U.S. economy, CBO said. It predicted interest payments for the debt alone would consume 6.3% of GDP by 2054.

Among major industrialized countries only Japan, Greece, and Italy have higher ratios of debt to GDP than the United States.

The industrialized countries’ average ratio rose in the early years of this decade due to deficit spending to combat the health, financial, and economic effects of the COVID-19 pandemic.

In explaining its AA-plus rating on the U.S. sovereign rating, for strengths Fitch Ratings in March pointed to the size of the U.S. economy, high per capita income, “dynamic” business environment, and use of the U.S. dollar, “the world’s pre-eminent reserve currency.”

For negatives, it mentioned high fiscal deficits and interest burden and government debt “well over two times the ‘AA’ medians.” “Standards of governance in the U.S. have steadily fallen over the last two decades while political polarization has risen.”

S&P Global Ratings in March affirmed its AA-plus rating of the United States and provided a similar analysis to the Fitch analysis.

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