All eyes are on Washington this morning as market participants focus on the potential government shut-down and the fiscal restraint that is bound to come out of current budget negotiations. All of this uncertainty has had the expected effect of pressuring equities and maintaining a firm tone in Treasuries.
With relatively little new issue supply to digest, the tax-exempt market has also continued to rally this week, but at a more modest pace. Market participants are breathing a sigh of relief at a sharp decline in outflows from the mutual funds. For the week ending September 25, according to Lipper, weekly reporting funds lost only $159 million, down dramatically from the previous week’s $1.10 billion. While one week doesn’t yet make a trend, one can only hope that a turnaround in fund flows is finally underway.
Looking beyond the market’s recent bounce, we wanted to ask the question: have municipals actually become a fundamentally riskier asset class, given the events of the last four months? Although muni ratios above 110% are clearly too high, could one make the case that the risk profile of the entire asset class has risen, and that tax-exempt rates should consistently exceed Treasury rates going forward?
Just because Detroit was forced into Chapter 9 doesn’t mean other troubled cities will choose to go down the same path.
Even before the advent of bond insurance back in the 1970s, tax-exempt bonds issued by large, rated municipal entities have always been viewed by US investors as extremely creditworthy, perhaps second only to Treasuries. Even the Depression-era wave of defaults yielded few outright monetary defaults as troubled municipal entities would always find a way to make bondholders whole, even after missing a few interest payments. Since then, investor confidence has indeed been borne out by the sector’s miniscule default rate over the last 30 years. Even the few headline-making bankruptcy cases have not always resulted in actual monetary default, as we saw with Orange County.
All this may be about to change. On October 1st, the City of Detroit will default on some of its G.O. debt, even as it tries to qualify for Chapter 9 proceedings. While this widely anticipated event shouldn’t have much of a market impact, its symbolic significance could be substantial: this will be the first default on a G.O. bond issued by a major city since New York City actually missed a coupon payment back in 1975. Clearly, “too big to fail” no longer applies to munis, if it ever did.
The outcome of the Detroit case may lead to a re-assessment of the fundamental creditworthiness of the muni sector, but not for the reasons usually advanced in the media. We, for one, don’t believe in the “Domino Theory” of muni bankruptcies. Just because Detroit was forced into Chapter 9 doesn’t mean other troubled cities will choose to go down the same path. In fact, the relentlessly negative press coverage Detroit has received to date, along with the escalating costs of litigation, could act as deterrents to future bankruptcy attempts. Although there’s always the lingering fear from investors that other cities will use bankruptcy as a tool to restructure pension obligations, we would argue that there are more incentives than ever before for all parties to try to reach a settlement outside bankruptcy court.
A recent Bond Buyer article points out, “the [Detroit] default will test some of the most traditional beliefs in the municipal bond market.” As we’ve noted before, the low historical bankruptcy rate in munis has been both a blessing and a curse for the asset class. Indeed, the relative scarcity of legal precedents has allowed Detroit’s legal team to advance corporate-style restructuring concepts as it tries to extract concessions from various classes of claimholders.
For the first time in many years, municipal investors are getting compensated again for assuming risk, particularly credit risk.
One of the potential casualties of this process is the “full faith and credit G.O. pledge,” long considered “sacrosanct” by muni investors. Instead of standing at the very top of a municipality’s capital structure, the G.O. pledge now runs the risk of ending at the bottom, should Detroit succeed in lumping G.O. debt with all other “unsecured” claims, including pension liabilities.
Even within the “unsecured claim” category, the relative priority of pension obligations (which may ostensibly be protected by state law, depending on the state) versus G.O. debt obligations will also have to be determined. The same goes for pension obligations versus pension bond debt service.
So, by the time the Motor City exits bankruptcy, assuming it even qualifies for it, investors will be looking at a fairly radical re-ordering of the claim priority of various municipal obligations. And, more than ever, the issue of “willingness to pay versus ability to pay” will have to be incorporated into muni risk pricing.
Away from Detroit, the potential systemic risk posed by the Puerto Rico situation may also be contributing to the current perception of munis as a riskier investment. Although other states, e.g. California, have gotten into trouble before, we really don’t have any historical precedent involving a quasi-sovereign entity with as broad a market impact as Puerto Rico. Let’s face it: the market never really contemplated a true default scenario for the Golden State. In PR’s case, rightly or wrongly, the market is telling us a restructuring is in the cards, with many PR issues trading on a dollar price rather than yield basis. The endgame here could well be a permanent shift in ownership of PR paper, away from the traditional muni funds and toward high yield funds and crossover buyers.
Now let’s consider the muni market’s current technical condition. We’re looking at a market that, along with other spread sectors such as corporate bonds, has lost a tremendous amount of liquidity since the Great Recession. According to the latest Federal Reserve report, broker-dealers’ holdings of munis hit a 10-year record low of $19 billion in the second quarter of this year, a 38.7% decline from $31 billion at the end of the first quarter. This decline in liquidity, coupled with a massive loss of demand from mutual fund redemptions, may go a long way in explaining why municipals underperformed Treasuries so dramatically over the summer.
The speed and severity of the market sell-off over the summer and the subsequent sharp rebound over the last two weeks might be a precursor of things to come; extreme volatility may become the norm going forward. The good news is: this volatility should cut both ways and this is where the reward side of the equation comes into play.
The current market environment is particularly propitious for institutional investors such as banks and insurance companies. Under Basel III, the risk weighting for revenue debt would be 50%, versus 20% for G.O. debt. Clearly, global bank regulators have not caught up with the fact that, in the post-Detroit environment, some G.O. debt may actually be riskier than revenue debt and may be priced accordingly. This loophole may allow the banks to buy higher-yielding G.O. paper without having to commit more capital, assuming they can assess the underlying credit risk correctly.
The steeper yield curve and higher yield levels, both on an absolute and relative basis, should help insurance companies, particularly those in the life sector, in their asset-liability matching efforts. Depending on their risk appetite, some of the life insurers may also consider the high yield and distressed muni sector, where opportunities typically require a longer holding horizon to come to fruition. As we pointed out in recent articles, high yield municipals currently benefit from an attractive combination of both wider spreads and higher absolute yield levels, against a backdrop of largely improving credit fundamentals.
Further potential upside may lie in the very factor that has historically detracted from the appeal of munis in the eyes of global investors: the quality of municipal disclosure. Compared to disclosure practices in other fixed-income asset classes, the tax-exempt market has remained in the Dark Ages, in spite of the best efforts of the MSRB. How can the market correctly price muni credit risk when critical financial data can be released as much as 18 months after the fact? (For more on muni disclosure practices, see “Does Muni Bond Credit Quality Impact Annual Audit Times?” which highlights the findings of Merritt Research Service’s third annual study of financial reporting times.)
Technology may hold one of the keys to future improvements in muni disclosure. For example, the adoption of the XBRL (“eXtensible Business Reporting Language”) format, already used in the corporate arena, would facilitate extraction of financial data from state and local disclosure documents, in contrast to the largely manual process currently required by the PDF format. In a recent Bond Buyer Commentary, Marc Joffe and Sharon Sohl made the case that adoption of the XBRL standard may eventually result in lower financing costs for state and local governments. To the extent that a disclosure premium is currently built into tax-exempt spreads versus corporates, any future improvement should lead to significant spread compression relative to other fixed-income instruments. While the promise of greater market efficiency through technological innovation is always tantalizing, there’s no doubt that significant hurdles still remain on the way to an effective adoption of XBRL.
For the first time in many years, municipal investors are getting compensated again for assuming risk, particularly credit risk. A market in disarray is a market rife with opportunity. It’s also a market where individual investors should tread carefully. Given the rising level of credit complexity and the higher level of rate volatility, it does behoove investors to seek out the help of professional managers whenever possible.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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