Inconsistent Liquidity and Confounding Market Moves: The US Bond Market Bayou
For decades, US municipal bonds were perceived as a relatively low-risk, buy-and-hold investment for individual investors drawn to the tax-free income stream they provided. Defaults in the market were rare — less than fifty between 1970 and 2007 — and while occasional high-profile fiascoes occurred from time to time, like the $2.2 billion “Whoops!” default of the Washington Public Power Supply System (WPPSS) in 1983 and the 1994 derivative-driven bankruptcy of Orange County, California, these were exceptional cases in a market that has now grown to $3.7 trillion in outstanding issuance.
Like everything else, the stability of the muni market was shaken in the financial crisis, which put pressure on the revenue base of many municipalities and hammered their pension fund investments, while doing nothing to reduce massive and growing pension and benefit obligations pledged to former and current employees. A series of large and well-publicized insolvencies commenced: Vallejo, California; Jefferson County, Alabama; and Detroit; with some others in between and Puerto Rico now coming fast. More than 20 municipal issuers have defaulted since the beginning of 2007.
We recently held our annual wealth management conference in Garden Grove, CA, where Peter Coffin, president of Breckinridge Capital Advisors, gave us his updated views on the ways that investors can navigate the complicated bayou that the US municipal bond market has become.
According to Coffin, one recent factor contributing to the muni market’s volatility is a series of changes in the way that rating agencies assess and rate municipal credit. This began with Moody’s wholesale “recalibration” of its municipal ratings in 2010, which Coffin said resulted in ratings upgrades for a “huge swath” of the muni market without additional analytical review. Moody’s followed up in 2013 with a new approach to assessing municipal pension obligations, which immediately resulted in 29 issuers being put on review for possible downgrade. (S&P followed with its own rating criteria revisions for general obligation debt later in 2013.)
These developments have taken their toll on muni-market confidence, and coupled with mid-year market anxiety about Fed “tapering,” have no doubt contributed to the record $64 billion in outflows experienced by municipal bond funds in 2013.
While fund flows seem to have reversed in early 2014, Coffin recommends caution even now. In his view, the Fed has begun what will likely be “a long, protracted process” of normalizing interest rates.
“I would make the case that a bond fund is a total return story, and it’s not a favorable view right now. Our hope and expectation is that the [Fed’s] adjustment will be measured, but we’re in a rising rate environment,” which could have a negative impact on bond prices.
Turning to the question of municipal credit quality, Coffin noted that most credit trends were “stable to positive,” despite scary headlines about Puerto Rico. The combination of rising home prices, improving economic indicators, and the positive investment performance of equity-heavy municipal pension plans — a gift of the buoyant equity markets — has contributed to a better credit profile for many municipalities. While Puerto Rico’s roughly $70 billion in outstanding issuance remains a serious concern, “I would never describe Puerto Rico as a potential systemic risk,” Coffin said.
There have been improvements in the near-term picture, but pension obligations are still a huge problem for many issuers, and therefore to bond investors. “A lot of these liabilities are, in the long run, simply unfundable” said Coffin. He suggested that it isn’t particularly difficult to estimate a timeline to insolvency for the most at-risk issuers by comparing their disclosed pension liabilities with their likely sources of funding over a period of time.
The exit of AAA-rated bond insurance providers, another change wrought by the financial crisis, has also changed the dynamics of the municipal bond market — but Coffin doesn’t necessarily see this as a bad development. He thinks that bond insurance is a source of potential moral hazard that could lower a troubled issuers’ threshold for default.
“Historically, muni investors were often locals who had a relationship with the issuer, creating pressure not to default. Bond insurance has come between that,” Coffin said, noting that the decision to default on an insurance company is easier than the decision to default on your own voting constituents. “Warren Buffett realized this and withdrew Berkshire Hathaway from the bond insurance market.”
Coffin noted that bond insurance companies have been downgraded and are no longer writing insurance for the market. By most estimates, they appear sufficiently capitalized to cover potential future claims on previously insured deals.
While credit challenges remain in the US municipal bond market, investors should be careful about comparing it to other credit markets.
“Keep in mind there is yet no evidence of systemic defaults in the [muni] market,” Coffin said. “Municipalities are monopolistic. In the short term, they are not exposed to the competitive pressures that exist in the corporate credit market.” He added that, under Federal contract law, municipalities must prove insolvency before restructuring bonded debt. “There will never be a systematic repudiation of debt in the muni market.”
Issuer responses to financial distress may vary state to state, and could include a Chapter 9 bankruptcy in rare cases, but they are more likely to involve changes in law to alleviate the pressures of insolvency. Examples could include appointing a control board or receiver, requiring state approval of annual budgets, asking the pension fund to lend to the government, or receiving state aid in exchange for reforms.
Some issuing entities seek to create special financing vehicles in response to financial distress, a strategy Coffin finds “ominous and troubling” because of the credit implications for existing bondholders.
In cases where Chapter 9 comes into play, Coffin said revenue bonds that have a proven lien on a defined revenue stream, such as a specific usage or licensing fee, would likely remain outside the bankruptcy estate and shouldn’t be subject to the automatic stay by the bankruptcy court.
But that’s not to say that even tightly pledged revenue streams can’t falter in cases of extreme financial distress.
“As some have said of Detroit, ‘When you’ve gotten all the blood from the stone, everyone is unsecured,’” Coffin warned.
Asked if he had particular credit concerns about any sectors of the California muni market, Coffin said he was reasonably comfortable with the credit of California school districts, but that 17 of the state’s water authorities are “in dire shape” in part due to the impact of the ongoing drought.
On the dynamics of the municipal bond market, Coffin noted its inconsistent liquidity and confounding market moves.
“Nobody in the muni market believes in the efficient market hypothesis,” he said. “We swing from overbought to oversold and are correlated to nothing.”
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