The nation's political balance shifted more forcefully this month than it has at any time since 1954, and we are about to enter a world where Republicans control the Senate, the House, and 30 state governorships. It will be different from the 1970s, the 1980s, and the early 1990s, and it could turn out to be beneficial for municipal bonds. Bond investors, though, may be buffeted more than they expect.
The Republicans are committed to lower taxes and smaller government, and they have pledged to do away with unfunded mandates. If they succeed in reducing spending as they trim taxes, overall fiscal strength will improve, and that will be good news for bondholders.
But lower taxes, smaller government, and elimination of unfunded mandates may mean continued decline in the volume of municipal bond issuance, and that won't be good news for people in the muni bond business -- underwriters, raters, insurers, and information purveyors. Portfolio managers may have fewer bonds to choose from.
It's hard to know whether or not the credit quality of municipal bonds will improve. Budget deficits and over-issuance hurt credit quality, and it's too early to say what will happen to deficits and bond issuance patterns. If states and cities can reduce spending as fast as they can cut taxes, they will wind up stronger fiscally, and that will improve the credit standing of their bonds. If they rush to cut income before they eliminate deficits and slenderize spending programs, the rating agencies will question the strategy, and downgrades will eventually follow. The recent record of states under GOP governors, however, should be encouraging to municipal bond investors.
Eliminating unfunded mandates, a move high on the wish list of state governors and city mayors, is almost certain. Bob Dole, Senate majority leader-in-waiting, told the 30 Republican governors and governors-elect in Williamsburg, Va., last week that the first Senate bill to be introduced in the new session will deal with limiting the federal government's practice of laying down rules without providing the money to carry them out. If mandates are funded, states and cities will borrow less.
In the broad trend toward lower taxes and smaller government, bondholders will have to keep alert to decreased revenues. Last week, for example, New Jersey officials announced that starting in March of next year they plan to cut by 20% the amount of money hospitals receive to care for Medicaid patients, a reduction of $135 million annually. Bondholders who helped finance those hospitals should be aware, for many such revenue reductions are likely in the years just ahead.