Are Muni Bonds Creating Unsustainable Debt?

by Matthew Glans on February 11, 2011

photo by iandavid/Flickr, used under a Creative Commons license

Municipal bonds are the primary funds with which cities and counties build and improve their infrastructure. Properly used, municipal bonds are useful tools that improve cities while not placing too much of a financial burden on taxpayers. Improperly used, municipal bonds and the debt that accompanies them can overwhelm the budget of a municipality and harm taxpayers through tax hikes and loss of services.

The current debate today over municipal bonds revolves around two issues: the growing debt of municipalities nationwide and the possibility of large scale defaults; and the subsidization of municipal bonds by the federal government through the Build America Bonds program.

Conservative groups like the Manhattan Institute argue that the growing budget problems many communities are facing are rooted in bad debt partially from municipal bonds used to fund government projects. In some cases these bonds are used to fund projects that the private market would not invest in. Commonly cited examples include sports stadiums, convention centers and airports, some of which are private ventures and not for public use. Piling up long term budget debt can be toxic to new economic development and these groups argue that instead of relying upon bonds to finance new constructions, municipalities should rely instead on current revenues to fund new development, also known as “pay as you go.”

Some financial experts argue that the increasing debt facing many cities and counties could lead to widespread defaults, crippling the municipal bond market and making it difficult for any state or town to find funding for necessary projects. This view is not universal, a recent Barron’s article argues that while the level of debt in both states and cities is a problem, it is both highly concentrated in several problem states and limited primarily to a handful of municipalities whose finances were very poorly managed.

The second primary issue affecting the municipal bond market is the federally subsidized Build America Bonds program. Created as part of the American Recovery and Reinvestment Act, Build America Bonds are taxable municipal bonds that carry special tax credits that are designed to lower the cost of borrowing for both state and local governments and government agencies.

The effect of the subsidized bonds on the overall bond market was profound. Many of the bond program’s supporters credit the subsidized bonds for saving the bond market during the recession by making it cheaper to issue long-term debt when traditional tax-exempt municipal bonds were too expensive or unavailable. As of December 2010, according to Thomson Reuters, nearly $180 billion in debt was issued under the program. Overall the bonds issued under the Build America Bonds program accounted for more than a quarter of the years total municipal bond issuance.

Critics of the program argue that the subsidized bonds distorted the overall municipal bond market, bringing down prices and encouraging new debt that many communities and states were unable to afford long term. Steve Malanga of the Manhattan Institute calls the potential defaults facing many state and local governments a “debt bomb.” The Build America Bonds program was not extended at the end 2010 and expired at the beginning of 2011.

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