Bond Yields Surge, Pressuring Local Borrowing Costs Amid Fiscal Uncertainty

In recent weeks, U.S. Treasury yields have climbed sharply, with the 10-year note nearing 4.6% and the 30-year bond surpassing 5%. This upward movement, driven by a combination of inflation concerns, fiscal policy debates, and shifting investor sentiment, is poised to impact borrowing costs across the nation, particularly for local governments seeking to finance infrastructure and public service projects resulting from past and projected severe weather.

Drivers Behind Rising Yields

Several factors contribute to the current rise in bond yields. Inflation remains a persistent concern; the U.S. Consumer Price Index (CPI) rose by 3% in January, exceeding expectations and marking an increase from December's 2.9%. This uptick, driven by higher housing, food, and energy costs, suggests that inflationary pressures are not abating as quickly as hoped.

Additionally, fiscal policy debates are influencing investor behavior. Moody's recent downgrade of the U.S. credit rating to AA1 reflects concerns over the nation's fiscal trajectory, with the budget deficit standing at 6.4% of GDP and national debt nearing historic highs. The potential extension of tax cuts and increased government spending are expected to add further to the debt, prompting investors to demand higher yields as compensation for increased risk.

Moreover, the U.S. faces a significant refinancing challenge; in 2025, approximately $9.2 trillion of government debt will mature or need to be refinanced, representing over 25% of the total national debt. This substantial supply of new debt issuance exerts upward pressure on yields as the market absorbs the influx.

Implications for Local Governments

The rise in Treasury yields directly impacts municipal bond markets, including climate bonds, as local governments often benchmark their borrowing costs against federal rates. Higher yields mean increased interest expenses for municipalities issuing new bonds or refinancing existing debt.

For example, a city planning to issue a $100 million bond for infrastructure improvements might have anticipated a 3% interest rate based on previous market conditions. With current yields, that rate could rise to 4-5% or higher, translating to an additional $1-2 million in annual interest payments over a 10-year term. Such increases can strain local budgets, potentially leading to delayed projects or higher taxes to cover the added costs.

Furthermore, the higher borrowing costs may deter some municipalities from pursuing necessary capital projects, impacting public services and economic development initiatives. Communities with lower credit ratings or limited fiscal flexibility are particularly vulnerable, as investors may demand even higher yields to compensate for perceived risks. Coastal communities are particularly at risk due to the growing frequency and scale of severe storms.

Market Outlook and Projections

Analysts project that the upward trend in yields may continue. A Reuters poll indicates that 10-year Treasury yields could surpass 5% in 2025, driven by persistent inflation and cautious Federal Reserve policies. While the Fed has signaled potential rate cuts, the pace and extent remain uncertain, especially if inflation does not align with the 2% target.

The term premium—the extra yield investors require for holding longer-term bonds—has also increased, reflecting heightened uncertainty about future economic conditions. This shift suggests a fundamental recalibration in the bond market, with long-term yields remaining elevated even as short-term rates potentially decline.

This recalibration also might bring into play a factor influencing pricing not seen in the bond market for decades: negotiation. A small community floating a $100M bond may not fund many willing buyers at 5%, but that same buyer may present an offer at 5.5% for the first $50M and 6% for the second - take it or leave it! Absent other options yet presented with a critical infrastructure project the power in the negotiation is entirely on the side of the buyer.

Strategies for Local Governments

In this challenging environment, local governments may need to adopt more strategic approaches to debt management. Options include:

• Timing Issuance: Delaying bond issuance in anticipation of more favorable rates, though this carries the risk of further rate increases.

• Debt Structuring: Exploring variable-rate debt or shorter maturities to reduce interest expenses, while managing associated risks.

• Credit Enhancement: Improving credit ratings through fiscal discipline can lower borrowing costs by reducing perceived risk.

• Alternative Financing: Considering public-private partnerships to fund projects without incurring additional debt. Philanthropy remains and option but is unlikely to scale to meet the ongoing demand; only a select few non-profits are responding to the need that can scale to meet the demand.

As the bond market continues to evolve, local governments must remain vigilant, adapting their financial strategies to navigate the complexities of rising yields and fiscal uncertainty.