Putting a Tough Week Behind Us

Between the events in Boston and the disaster in West, Texas, it was, as President Obama remarked, “a very tough week.” Stock market participants would also agree with that assessment, as the first wave of Q1 earnings has, so far, proved quite lackluster. The ensuing selloff in equities has provided good support for the fixed-income market, with municipals roughly keeping pace with the move in Treasuries.

While interest rate risk is built into any fixed-income instrument, certain idiosyncratic features of the muni market may exacerbate the potential downside volatility for muni investors.

Treasury rates, which are now near the 2013 low marks, will be tested this week by new 2-year, 5-year and 7-year auctions.

Meredith Whitney, Is Thy New Name … Gallagher?

Securities & Exchange Commissioner Daniel Gallagher created bit of a stir last week when he warned muni investors of a potential “Armageddon” during the SEC Roundtable on Fixed Income (another panelist also referred to an upcoming “tsunami” of bad news for the tax-exempt market). When asked to clarify his remarks, Commissioner Gallagher pointed out he only wanted to “educate” retail investors, not scare them. To us, this is tantamount to telling your children the house will burn down if they don’t do their homework!

If this were the year 2012, we’d be tempted to take Commissioner Gallagher at his word. However, since the world did not end last year (as far as we know), one might ask what triggered such a gloom-and-doom posture from our regulators.

Apparently, the sources of the SEC’s concerns regarding the muni market are two-fold: First and foremost, there is the small matter of interest rate risk, particularly since tax-exempt yields are currently at or near historical lows. When you’re buying long-term bonds at a yield of 2.00%, the probability of yields rising from that level and leading to capital losses is certainly much greater than the probability of yields declining and creating capital gains. After all, rates can only go down another 200 basis points before they hit zero, while they can easily rise by 300 basis points or more just to get back to long-term historical norms.

While interest rate risk is built into any fixed-income instrument, certain idiosyncratic features of the muni market may exacerbate the potential downside volatility for muni investors.

For one, unlike most fixed-income investments, with the exception of certain corporates, munis typically come to market at par with an early 10-year call provision. This means their upside in terms of price appreciation is capped by the call provision while their downside is pretty much unlimited (this is what technical geeks usually refer to as “negative convexity”).

Secondly, because retail investors reportedly own almost 75% of the outstanding muni supply, much of which through retail proxies such as the mutual funds, any selloff tends to become circular and self-fulfilling: a significant rate rise might trigger a decline in the funds’ net asset values, leading to redemptions from fund investors; the redemptions would then force the funds to liquidate more of their holdings, which, in turn, would put even more selling pressure on the overall market. We saw this happen as recently as late 2010, when Meredith Whitney made her now infamous prediction.

Thirdly, once muni bonds start to trade at a discount in the secondary market, the so-called “de minimis” rule will kick in. In effect, the rule requires the buyer to pay ordinary income taxes on the so-called “market discount” on his bonds if such discount exceeds an allowable “de minimis” level (generally speaking, a market discount is recognized if the purchase price is less than the bond’s tax basis). While we won’t go into all the mechanics of the rule here, suffice to say that “de minimis” considerations may amplify any market selloff as traders will require increasing yield compensation for the taxability of the market discount.

Last but not least, and this is admittedly a very technical point, because of their tax-exempt status, municipal bonds cannot be sold short, which makes them difficult, if not impossible, to hedge. Because broker-dealers and other market makers cannot effectively hedge their inventories, market liquidity during prolonged bear market periods may suffer accordingly.

Away from pure interest rate risk, the SEC has also expressed concern about the Stockton bankruptcy and its potential impact on recovery rates in the event of default. Apparently, the SEC believes many muni investors don’t realize that, in the event of default, they may not get all of their principal back (!) Surely, this observation could only apply to holders of the highest quality full faith and credit bonds, since everyone else must be aware that credit risk, and therefore potential losses, can occur in any credit-based investment. As we pointed out in last week’s column, one cannot draw any conclusion about G.O. recovery rates from either the Stockton or the San Bernardino cases. At best, the way pension funding issues get resolved through bankruptcy may lead to a re-appraisal of the risk/return characteristics of already risky instruments such as pension bonds and lease revenue bonds.

So are we doomed to witness Armageddon? Hardly. While it is true that most bond investors who came into the market over the last 10-15 years have never experienced a bond bear market, weak current economic conditions here and overseas make a significant rate spike improbable in the short-to-intermediate term, in our humble opinion. However, it is certainly reasonable to assume that, as the economy recovers, rates will ratchet up gradually. With a modest educational effort, and we do agree with the SEC here, it should be a fairly orderly process.

G.O. Bonds Revisited

Speaking of educational efforts, Kroll Bond Ratings, a relative newcomer to the bond rating space, just published a very informative report on General Obligation Bonds, titled “Not All G.O. Bonds Are Created Equal”. Truthfully, the biggest insight that came out of the current debate about municipal credit quality is the realization that there are wide variations in security features even within the generic G.O. category. A so-called “full faith and credit” pledge may not mean the same thing, depending on which State you’re referring to, as local governments’ statutory authority to levy and pledge tax revenues may differ sharply from State to State.

Likewise, as our friend and muni expert Bob Doty from AGFS has been telling investors, everyone should learn the difference between “General Obligation Bonds” and “General Fund Obligations”.

Interested investors can access the Kroll report here: Not All G.O. Bonds are Created Equal

Finally, Some (Relatively) “High Yield” Issues on the Calendar!

This week’s calendar looks to be a manageable $7 billion or so, after a competitive $350 MM New Jersey G.O. issue was postponed. The headline competitive issue will be a $435 MM G.O. offering from the State of Wisconsin.

The negotiated calendar, however, should be of great interest to income investors. Away from the run-of-the-mill $400 MM California State Public Works (A2/A-/BBB+), yield hogs may choose between a decent size below-investment grade health care deal ($295 MM Muskingum County, Ohio Hospital Revenue Bonds for Genesis Health Care, Ba1/BB+) and a $107 MM Baa3/BB+ subordinate lien issue from the Central Texas Regional Mobility Authority.

Looming out there in the shadow supply is the $1.2 Billion unrated Iowa Fertilizer deal, the largest high yield muni issue ever. This issue is slated to come to market by the end of the month and, given the current dearth of yield paper in the market, its timing certainly cannot be any better.


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