From a rates market to a credit market

February 22, 2012

I attended two events in the last few days that featured top muniland bond fund managers discussing the markets, and a theme that kept coming up was how the financial crisis had substantially changed muniland. In nearly identical language, three fund managers said the market has changed from a “rates” market — where trading and portfolio decisions were made based on interest-rate movements — to a “credit” market, where buying decisions pivot on the credit quality of individual bonds. This is a sea change for the business and has driven more demand for credit analysts in muniland. It has likely caused a growing reliance on official credit ratings among individuals and firms that can’t do credit analysis.

Why this change? Up until the financial crisis, bond insurers like MBIA, Ambac, FSA, and FGIC used their AAA status to “wrap,” or insure, the credit quality of municipalities and conduit projects that had less than sterling credit quality. Let’s say, for example, that a municipality gets rated by a credit rating agency at the A- level, or six notches below AAA. Rather than paying a higher interest rate when they issue new bonds, the A- issuer would turn to the AAA bond insurer who, for a fee, would put their guarantee on the bond for its repayment. The insurer’s guarantee would raise the credit rating of the wrapped municipality to AAA. The issuer pays an insurance premium for the privilege of borrowing the AAA and saves the difference between raising money with an A- rating versus the AAA rating.

Just under 70 percent of municipal bonds were AAA in 2007. This fell to about 35 percent in 2008 and about 14 percent in 2011 (see an excellent chart on page 8 of the presentation by Sean Carney of BlackRock). The massive decline in the quantity of AAA bonds was caused by the blowup of the municipal bond insurers in 2008. Insurers, in addition to guaranteeing safe municipal bonds, had wrapped misrated mortgage-backed securities, which devastated the insurers’ credit quality as the crisis accelerated. When the bond insurers lost their AAA rating, all the bonds they had wrapped also lost their rented AAA rating.

When 70 percent of muniland was insured and had a AAA credit rating, there was no need to dig down into the credit quality of the underlying bond. This is what the three muni bond fund managers were talking about — they were trading mostly on an interest-rate basis. But the insurers’ loss of their AAA status ruined this approach to the municipal market. Market participants were left with two choices: either use credit ratings from an official rater or evaluate the securities with in-house credit analysts. Both approaches are more time-consuming and complex than just worrying about changes in interest rates.

This change also puts a lot more pressure on the credit rating agencies — primarily Standard & Poor’s, Moody’s, and Fitch — to keep municipal ratings up-to-date and well analyzed. I think we are seeing the raters play catch-up as they take over the surveillance role that insurers used to play.


Municipal Analysts Group of New York: Video of speakers at luncheon meeting at the Yale Club, Feb. 17, 2012

Municipal Analysts Group of New York: Luncheon meeting speaker presentations

Bloomberg Link: Municipal Bonds: Risk or Opportunity

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