The municipal bond market and the EU
Recently the International Monetary Fund and David Wessel of the Wall Street Journal compared market dynamics for European sovereign bonds and U.S. municipal bonds. I suppose the thinking was that America is a developed fiscal union and could offer lessons to the less politically unified EU, but it’s an impossible comparison. Europe’s market for sovereign debt and the U.S. muni market have practically nothing in common except that they are composed of bonds and trade over-the-counter. They display idiosyncratic behaviors based on fiscal practices, market structure, securities ownership, market liquidity and their use as collateral at central banks.
The most basic difference is ownership. In the case of U.S. municipal bonds, households hold over half of the $3.7 trillion market (seen above). Retail-bond ownership is typically very stable, and most investors buy and hold bonds til maturity. American banks hold less than 10 percent of the muni market because they typically get little benefit from the exemption of federal, state and local taxes.
In contrast, EU sovereign bonds are widely held by European banks as part of their capital base as seen in this excellent Reuters graphic by Scott Barber. Scott’s graphic shows that the banks of every EU nation are deeply interconnected to other nations through their ownership of sovereign bonds. This interconnectedness creates channels for contagion to spread, but there is no equivalent for the U.S. muni market.
The main point the IMF team makes about the U.S. muni market flies in the face of actual market dynamics. From the paper:
Examining the ups and downs of 10‐year municipal debt from 2005 through early 2011, it finds that an increase in borrowing costs in one state generally results in lower borrowing costs in others.
Arezki, Candelon, and Sy of the IMF are suggesting that investors are herding around the states in a collective yield-seeking stampede, selling the bonds of one state as they purchase the bonds of another state. This may be true for some mutual funds (who hold approximately 22 percent of the market) but most market participants have substantial costs as they enter and exit trades. Market yields for states move pretty much in lockstep with each other. Daniel Berger of Thomson Reuters Municipal Market Data wrote that the yield relationship between states that the IMF was implying was a “zero‐sum” game:
[Neither] academic study describe or explain relationships between trading levels of various states. One is left to believe that the yields of several large municipal bond issuers are a “zero‐sum” game.
There is one interesting outlier to this characterization, though: Puerto Rico. Its debt is granted tax exemption in every state because of its status as a U.S. territory. It moves in its own pattern untethered to any other state and moves on supply and demand.
Chart source: Thomson Reuters Municipal Market Data AAA yield