Eventually the piper must be paid. For municipal governments, balancing the budget is these days a constant concern and budget cuts are starting to hit core services as the recession plods along. In Washington, however, balanced budgets are not a concern, nor it seems is the staggering deficit that comes with massive spending programs that have no tax revenues to support them. The national deficit will reach 10% of total GDP this year and that deficit is being financed with US Treasury bonds that will be issued to investors in the amount of one-trillion dollars. While recent conditions have been favorable to national borrowing and lower rates, those conditions are now changing…and not for the better.
Demand for US Treasuries has been strong up to this point in part because of investor concern over fiscal crises in Europe and lack of quality alternative investments in the US economy. Now, as the EU gets things under control with Greece, and demand for corporate bonds returning, there has been a fall in demand for US Treasuries. Lack of demand means that if the US wants to sell bonds (a trillion dollars of them), then it will have to offer better yields (rates) to investors. That means the historically low rates paid by the US on its sovereign debt is expected to increase. It’s a trend that many see lasting for the foreseeable future as deficit spending continues unabated in Washington (click for WSJ article).
That’s bad news for you and I as US citizens, but it is also bad news for us for other reasons. When US Treasury rates increase, rates for most other things increase as well. That’s because US Treasury instruments make up a “floor” called the “risk-free rate” that is the first building block for virtually every other interest rate in the world. The prime rate, LIBOR, mortgages, corporate bond yields, and even expected returns on the stock market have a tie to the risk-free rate, which is normally indexed to the long-term US Treasury Bond. If the risk-free rate increases, all other rates increase too.
That includes the rates for municipal bonds, a critical financing vehicle for water and wastewater utilities as they look to fund infrastructure replacement and upgrades to major facilities. Since the US Treasury rates have been low, so have municipal bond rates. Highly-rated municipal bonds have enjoyed rates hovering within 50 basis points of 4% for quite a while now, but if interest rates get upward pressure thanks to what’s going on in the treasury markets, then utility managers should expect upward movement in municipal bond rates as well. Higher borrowing costs translate into higher debt service, which translates into higher water rates and higher wastewater rates. Eventually, the piper must be paid.