The perils of unrated municipal bonds

February 2, 2013

It is extremely rare to see a muniland market professional pitch a specific bond to the public. In fact, I’ve never seen an analyst or a portfolio manager do it in the general media. So I was more than a little shocked to see Alexandra Lebenthal pitching a newly issued unrated bond on Maria Bartiromo’s show on CNBC.

Unrated bonds inhabit a dark corner of muniland. An August 2012 study by the Federal Reserve Bank of New York highlighted that default rates for unrated bonds have historically been 36 times higher than rated bonds. Here is how the New York Fed puts it:

Our findings raise the question, what causes such markedly different default frequencies between rated and unrated municipal bonds? Our answer: Not all municipal bonds are created equal. Different types of municipal bonds are secured by very different revenue sources with varying levels of predictability and stability. Furthermore, we believe that rated municipal bonds tend to be self-selected: issuers are less likely to seek ratings if their municipal bonds are not likely to achieve investment grade ratings.

Unrated bonds are the Death Valley of muniland. They should never be promoted to a retail audience. In fact, Lebenthal does a dance trying to buffer the dark alley she is leading her audience down. From the CNBC transcript of Lebenthal:

And I’ve said this a lot over the last couple of years, with all the things that have gone on, I would have a professional managing my municipal money, whether it’s in a mutual fund, an ETF or separately managed account… I wanted to give people an example of what the maximum yields are that are out there. We have non-rated bond, and typically we don’t sell non-rated bonds and wouldn’t normally recommend that, but as you can see, if it’s showing on the screen right now, it’s 100 basis points above the other bond that I haveand — look at the coupon, but what you really want to look at is the yield to call, and that bond is priced to call, so that 4.37 is the yield to call in 2020 or 2022.

Lebenthal is waving an extremely risky bond in front of clients, and she says don’t worry about how stinky it is, it has a great coupon! She never mentions the risk.

The crazy thing is that she is not saying this to some young trust fund client who can absorb massive risk for higher returns, she is saying this to the general public.

This is on the cover of the bond offering document for this unrated security:

Investment in the 2013 Bonds involves risks that may not be appropriate for some investors, especially because the taxable property in the Community Facilities District is not completely developed.

This is a very convoluted deal that relies on special tax payments from residential and commercial real estate holders in a “community facilities district.” In total, the bond offering document has 13 pages of “special risk factors,” and it has interest coverage that is very thin. This is way too complex for a retail investor to assess the relative risk of the bonds. And most big brokerage houses would never let their brokers offer it to their clients because it could easily blow up on the firm.

The same day that this unrated deal was brought to market, the Maine Healthcare Facility bonds came to market rated Baa1 and BBB, the lowest category of investment-grade securities. The ten-year portion of the deal had a yield of 3.25 percent, or about 112 basis points lower than the yield to call on the unrated bond of 4.37 percent that Lebenthal quoted. This suggests that the unrated bond was way down in junk category and the issuer was afraid to get it rated.

There is a FINRA rule concerning “suitability” of investments for retail investors. This unrated bond would meet the suitability criteria for very few investors and definitely not the general public. Recommending this, or any unrated bond, on television is not a good practice.

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