Fiction an easy sell in U.S. muni market

December 9, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Armageddon makes for a sexy story. Volatility in the $2.8 trillion U.S. municipal bond market is real, but the scary tale being spun out of budget-busting states like California involves a lot of literary license.

The rockiness of the market lately is shown by the surge in the perceived riskiness of muni bonds. The highest-rated issuers’ paper is trading at yields that are 0.5 to 0.8 percentage point higher than at the beginning of November. Meanwhile, investors in mutual funds that specialize in the sector pulled out $5.6 billion of their money in the five weeks to Dec. 1, the biggest withdrawal since the financial crisis two years ago.

The volatility seems to have been kicked off by technical factors rather than rising worries about state and municipal defaults. Surging Treasury yields, which underpin munis and other bonds, rattled the famously illiquid market; a flash-flood of new supply didn’t help; the future of the popular but temporary Build America Bond program is bound up in the Washington tax debate; and the related uncertainty over personal tax rates hardly fills investors in the tax-driven muni asset class with much confidence, either.

Moreover, munis have few natural buyers once any kind of exodus gets going. Their tax-exempt status makes them best suited for wealthy American investors who buy them to tuck away in portfolios. Retail investors hold more than two-thirds of outstanding muni debt, according to Federal Reserve data. That compares with U.S. Treasuries, where retail holders account for roughly 20 percent of the total, and equities where they account for less than 60 percent.

That arguably leaves the muni market especially vulnerable to perceptions. It’s true that higher yields make it more expensive for small issuers like cities, sewage authorities or school districts to raise funds. That could make a municipal default more likely — but only at the margin.

Meantime, the alarming-sounding deficits of some big states have attracted predictions of defaults from high-profile figures like bank analyst Meredith Whitney. Yet while a state default isn’t impossible, comparisons with, say, Greece or Italy are misleading. California’s debt-to-gross state product ratio is just 5 percent — minuscule compared with the Greek debt-to-GDP level of 133 percent, as estimated for the year-end by JPMorgan, or the U.S. federal government’s 88 percent.

The danger is that retail muni investors, in particular, read too much into the headlines and turn the perception of default risk into reality. They might be better off worrying about their “risk-free” holdings of Treasuries.

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