NEW YORK — Local government tax revenue has fallen for six straight quarters and states are trimming aid to municipalities. But that hasn’t deterred investors from pushing debt of cities and towns to the longest rally in five years.
With interest rates in the $3.7 trillion municipal-bond market at their lowest since the 1960s, the quest for yield is masking municipalities’ fiscal strains just months before potential federal spending cuts may sap local finances.
“You’ve had a tug-of-war between safety and the need for extra yield,” said John Donaldson, who helps manage about $700 million of munis as director of fixed income at Radnor, Pa.-based Haverford Trust Co. “The need for extra yield has been winning that tug-of-war.”
Debt of localities earned 1.6 percent in July, beating the 1.3 percent gain for state securities, Bank of America Merrill Lynch indexes show. It was the seventh consecutive month where local debt came out ahead, the longest stretch since 2007.
States and municipalities are still suffering from the 18- month recession that ended in June 2009. Three California municipalities have filed for bankruptcy since June.
Local property taxes, which help finance education, police and firefighting, fell 0.9 percent in the first quarter from the same period last year, according to a report from the Nelson A. Rockefeller Institute of Government in Albany, New York. Total local collections fell a sixth straight quarter.
Concern that European leaders would fail to contain their debt crisis helped push yields on 20-year general-obligations to 3.61 percent last month, close to a 45-year low set in January, according to a Bond Buyer index.
As yields dove, investors became more willing to stomach the added risk of local borrowings. Debt of cities and towns yields 3 percent on average, about 0.6 percentage point more than state bonds, according to Bank of America data.
A local issue in Pennsylvania last month shows the extra yield available for similar credits.
The Monroeville Finance Authority, which helps finance hospitals and health-care facilities, sold about $356 million of tax-exempt revenue debt in mid-July with an Aa3 rating, Moody’s Investors Service’s fourth-highest grade. The issue was on behalf of the University of Pittsburgh Medical Center. Ten-year bonds were priced to yield 2.55 percent. That was 0.75 percentage point more than 10-year general obligations that Pennsylvania, rated one level higher, sold the following week, data compiled by Bloomberg show.
States have reduced local aid as they closed a cumulative $500 billion of budget deficits in the past four years. In the case of New York, since fiscal 2009 the state has cut aid to municipalities by $50 million, or 7 percent, according to Comptroller Thomas DiNapoli.
Cities and towns may face additional pressure from the so- called fiscal cliff, which would amount to more than $600 billion in tax increases and cuts in government programs next year unless Congress acts. The Congressional Budget Office in May said an economic loss of that size would probably lead to a recession.
Localities may not have much more room to trim expenses, heightening the risk to those issuers if the economy does contract, said Chris Mauro at RBC Capital Markets LLC.
RBC forecasts the chances of a contraction in the next 12 months at 30 percent to 35 percent, said Jacob Oubina, senior U.S. economist in New York for Canada’s largest lender by assets.
Excluding education, local payrolls rose the past five months, the longest stretch of increases since 2008. For Mauro, that signals cities and towns may have reached the limit of worker cuts.
“Localities are the most vulnerable, we believe, of the sectors in the muni market to another recession,” said Mauro, RBC’s head U.S. municipal strategist.