Does the market trust corporate issuers more?

April 26, 2012

Darrell Preston of Bloomberg News wrote a great piece comparing the yields on trades of comparably rated corporate and municipal bonds. He highlighted that corporate bonds have a much higher risk of default than municipal bonds but have similar yields. His analysis suggests that risk is not being properly priced if in fact ratings between asset classes are comparable and that municipal issuers are paying interest rates that are too high.

Two years after Moody’s Investors Service and Fitch Ratings changed standards to put municipal credits on the same footing as corporates, California and Illinois are among states that still pay more for debt than similarly or lower-rated corporations, according to data compiled by Bloomberg. Yet Moody’s says companies default at 86 times the municipal rate.

“Taxpayers continue to get a raw deal,” said Tom Dresslar, spokesman for California Treasurer Bill Lockyer, who pressed for the rating changes. “Not much has changed.”

Preston’s article compares the yield for recent trades for the state of California and a private energy producer, which are rated at near-equivalent levels:

When California and A2 rated Idaho Power both sold 30-year debt this month, the utility’s bonds priced 6 basis points lower than California’s … according to data compiled by Bloomberg. The Boise company provides electricity for southern Idaho and eastern Oregon. The state is rated one step higher at A1 and offers tax-exempt securities to provide an incentive to investors to accept a lower yield.

Preston’s article addresses one of the most fundamental issues of the fixed-income markets. If credit rating agencies are doing their job accurately and rating bonds with similar risk at the same rating category, why is the market pricing the debt as if they are different?

Bob Nelson, who leads Thomson Reuters Municipal Market Data group responded to Preston’s article in a tweet of less than 140 characters:

Bob NelsonBob Nelson  @BNels22 you can blame tax-exemption, serial bond structure, poor disclosure for #muniland yield disparity

I interpreted Bob Nelson to be saying that the exemption from state and local taxes for investors who buy bonds of their state and the federal tax exemption of municipal bond interest is useful but not utilized uniformly by bond investors. For example, multi-state mutual fund managers are unable to uniformly use the muni tax exemption when managing a national portfolio of municipal bonds. The serial bond structure of many municipal bonds, where repayment of principal happens over the term of the bond, is not as attractive to institutional investors as a bond that has a lump-sum repayment at maturity (which is the standard structure of corporate bonds). Both of these factors create a lot of variation in how investors view the desirability of municipal bonds. Or said another way, there is so little standardization in the municipal bond space that investors require more yield because the risk of individual securities is harder to discern than in the corporate bond space.

The last point that Bob Nelson makes about poor disclosure in muniland is probably the most important. The regime that the SEC imposes on corporate issuers is much more rigorous than that for municipal issuers and gives investors much more transparent information. For example corporate issuers are required to file their quarterly financial reports 45 days after the end of the reporting period and their annual audited reports 90 days after the end of the reporting period. In contrast, the most recent audited financials for the Commonwealth of Puerto Rico, whose debt is broadly owned, is June 30, 2010. So a municipal issuer is sharing financial data that is 22 months old, versus a corporate issuer whose data is three months old. It’s easy to understand why the markets would charge additional yield for the uncertainty. And that does not even address the fact that certain very material events for municipal issuers, such as bank loans and derivative termination events, are not subject to mandatory disclosure, so investors need to guess about those events.

Bloomberg’s Preston has begun a very important discussion, and I would urge him and his colleagues to consider using the SEC-mandated credit rating data to do further analysis. The higher yields that markets require from municipal issuers are signaling something, and it could be ratings divergence, as Preston suggests, or market structure issues, as suggested by MMD’s Nelson. Mashing up historical credit ratings data with price data might shed some interesting light on the issue.

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After this blog post appeared Bob Nelson tweeted out:

@cate_long investors just know them better – better disclosure. #muniland

To be continued…

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