These are slugs. The one on the bottom is poisonous. You’ll find that one in Australia. Not to worry about these slugs and all their kin. They are doing just fine. It is more than likely that they will be around long after “intelligent” life is gone.

The slugs that may be going extinct are referred to as State and Local Government Securities. Those who use them affectionately refer to SLGS as “Slugs”.

SLGS are another of those weird things that make up our gigantic public sector debt. The total outstanding is about $210 billion. In the scheme of things that is peanuts. It is only 2.5% of the public debt. But who was it that said, “$200 billion here, $200 billion there….. Sooner or later we are going to run out of buyers".



SLGS are the product of a law dating back to 1969. The law limited and set rules for municipal bond arbitrage by large Muni issuers. It is (to me) an interesting and somewhat comical story.

States are allowed to issue Municipal bonds that are free of both State and Federal taxes. US Treasury bonds are fully taxable by the States and the Feds. If you assumed a person was in a State where their effective tax rate was 35% it would mean that a pretax Treasury bond yield of 5% was equal to 3.25% after tax. So if that person could buy a state muni that yielded 3.5% he would be well ahead on the investment (assumes no credit risk).

This arbitrage works the other way just as well. The States were able to issue long-term debt at 3.5% and invest in Treasury bonds with a similar maturity at 5%. States pay no taxes so this was just a way to coin money. And the States did just that all throughout the 60’s.

Forty-five years ago a few Wall Street bond traders, a number of lawyers and a bunch of State treasurers were ginning the system and creating an ‘early days’ derivative transaction that generated free income. Amazing how things have changed over the last half century. When it comes to financial engineering, the techniques are new. The motives are the same.

So in 1969 a ‘going broke’ Federal government put an end to the party. The SLGS were born from that.

SLGS have continued to provide an important role. They are used for Municipal Bond Defeasance. Think of this as if you had a 6% mortgage and now interest rates have fallen to 5%. You could (at least in the past) refinance the mortgage and save yourself some money every month. States are no different, but they face a problem. They can’t just pay off their old bonds. Those bonds all have call protection features. So those bonds can’t be prepaid or redeemed.

This is where the SLGS come into play. Here are the steps:

1) State has outstanding $10mm of a 10 year Muni at 5% callable in six years.
2) State can now borrow at 4%.
3) State borrows $10mm for ten years at 4%.
4) State uses the $10mm of newly borrowed funds and buys SLGS from Treasury that match the maturity of the old 5% bond.
5) State delivers the SLGS to a Trustee who receives future interest/principal payments from Treasury and who will disburses it to the old bondholders.
6) Upon the completion of #5 the old 5% bond is “defeased”. It is no longer either a cash or accounting liability on the State’s books. The State has achieved the desired savings in debt service expense and extended the average life of its liabilities.
7) On the call date (six years later) the bonds are called. The SLGS mature. The proceeds are used to pay back the bondholders. The Trust is dissolved.

Now you understand SLGS. Here's why I think they are a dying breed:

-A State can’t defease an old bond if the cost of new borrowing is higher that the old coupon.

-A State that was looking at a growing debt load would be nuts to defease old debt. They have to raise new money to meet current liabilities, forget about prepaying stuff that does not come due for 6 or 8 years.

-California is now borrowing at a premium to Treasuries. Many states will follow their lead. That is the end of the SLGS arbitrage.

-The biggest issuers of Muni's (and users of the SLGS window) are also the same States that are either now in trouble or are headed for trouble.

Here are some reports on SLGS outstanding. It is headed south and will continue to head south.

As the SLGS account runs down, the liabilities will have to be replaced, dollar for dollar, with “real” investors. The Chinese Central Bank, The Bank of England on behalf of the Chinese Central Bank, or possibly the mystical “households” and “others” will have to pony up for the increase.

Someone will point out that when SLGS mature an investor someplace gets cash and that investor will go out and buy some Treasuries to offset the shortfall. Sorry. It doesn’t work like that. Not when Ben B. has the ZIRP on. There are far too many better things to invest in.

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