Examining muniland’s indices after the Libor scandal

The muni market’s overseer, the Municipal Securities Rulemaking Board (MSRB), is taking aggressive action to survey muniland indices following the Libor scandal. The board is asking index providers to disclose more about how certain indices are developed. The MSRB has no direct authority to regulate indices because, as with Libor, they are maintained by private companies and are outside of the board’s legislative mandate to regulate dealers. Alan Polsky, the current chairman of the MSRB, said in a press call that the board did not believe that there was any wrongdoing in this corner of the market, but that increasing transparency would enhance investor confidence. Here’s what he stated in a press release:

“Like other regulators, the MSRB is concerned about the transparency surrounding the development of market indices,” said MSRB Chair Alan Polsky. “We plan to review indices used by the municipal market – and develop educational materials about their use – to ensure that the market operates fairly and transparently.”

This is exceptionally good news because the municipal markets generally lag behind the equity markets in the transparency of their indices. You could easily calculate the value of the Dow Jones industrial average yourself, because information on all of the Dow’s components are publicly available. The same can’t be said for the Bond Buyer 20 index.

Here are some of the widely used indices in muniland:

The indices about which we know perhaps the least, though, are tied to Markit’s municipal credit default swaps. They describe their CDS pricing process generally like this:

Markit receives contributed CDS data from market makers from their official books and records. This data then undergoes a rigorous cleaning process where we test for stale, flat curves, outliers and inconsistent data. If a contribution fails any one of these tests, we discard it. By insisting on the highest standards, we ensure superior data quality for an accurate mark-to-market and market surveillance.

Muniland’s bad boys

Last week I called Puerto Rico “America’s Greece” partly because of its financial statistics and partly because of its inclusion in the muniland bad-boy list maintained by Thomson Reuters Municipal Market Data. What the bad-boy list tells us is how much the bonds of the weakest issuers trade over the AAA benchmark. To put it another way, that difference is the premium the market charges for the risk of owning these bonds; it also reflects the premium the bad-boy issuers would have to pay to bring new bonds to market. For example, Puerto Rico, currently the weakest borrower on the list, would have to pay 225 basis points more than a AAA 10-year bond to borrow. Given that MMD AAA benchmark closed on Tuesday at 2.33 percent, that would mean an investor would demand a yield of 4.58 percent to buy a 10-year Puerto Rico general obligation bond. Also using Tuesday’s numbers, investors would demand a yield of 3.88 percent to own a 10-year California GO bond. This is how the market works — it punishes the weak.

Studying the chart above and table below you get a sense of the relationship between credit quality and the interest surcharge. The weaker the credit quality — that is, the lower the number or rating — the higher the interest paid. There are other factors that affect the premium, including the tax rates in the state (higher-taxed and wealthier states have lots of demand from their citizens for tax-exempt municipal bonds) and the recent supply of new bonds in the state. But the fundamental bond market truism remains: The riskier you are, the higher the interest rate you pay. In muniland these are the bad boys. Issuer Spread S&P rating Moody’s rating Debt & unfunded pensions Puerto Rico 225 BBB (6) Baa1 (6.5) $ 64 B Illinois 155 A+ (8) A2 (9) $ 86 B California 90 A- (7) A1 (8) $ 137 B Nevada 65 AA (9) Aa2 (9) $ 4 B Rhode Island 55 AA (9) Aa2 (9) $ 6 B Michigan 53 AA- (8.5) Aa2 (9) $ 19 B D.C. 43 A+ (8) Aa2 (9) $ 6 B New York City 43 AA (9) Aa2 (9) $ 161 B Ohio 35 AA+ (9.5) Aa1 (9.5) $ 14 B New Jersey 30 AA- (8.5) Aa3 (8.5) $ 60  B

Source: Municipal MarketData, Moody’s Investors Service, Standard & Poor’s Ratings Services, local government budget reports, official statements.

Munis haven’t been this hot since the ’60s

Municipal bonds had a spectacular performance in 2011. Now investors want to know whether last year’s shining returns can be repeated, or whether the mechanics of the bond market suggest that most of the gains for the asset class have already been made.

Muni yields are touching 45-year lows. Everyone wants muni bonds, but the supply has been very limited. The chart above maps the Bond Buyer 20-Bond GO Index, which is based on an average of certain general obligation municipal bonds maturing in 20 years with an average rating of Aa2 and AA. It’s a widely used general municipal bond index, and we can see that it is now hovering around 4 percent. Municipal bond yields have not been this low since the middle of the 1960s. It’s very hard to judge the direction of the market when it has been such a long time since similar conditions prevailed.

The chart below is a much more sophisticated way to view the municipal market relative to the Treasury market. What the chart depicts is the spread of 10-year Treasury bonds over the Thomson Reuters Municipal Market Data 10-year AAA benchmark. Demand for municipal bonds has been so strong that they are trading at a lower yield than the equivalent Treasury bond: The Thomson Reuters MMD 10-year AAA yield was 1.67 percent on Wednesday, versus a yield of 1.89 percent on the 10-year US Treasury.

Muniland on fire

In a sign of enormous investor demand, the benchmark for the municipal bond market hit an all-time low today. The Thomson Reuters MMD scale for AAA bonds maturing in 10 years finished the day at 1.82 percent, the lowest level since 1981.

This means an investor buying a AAA-rated tax-exempt bond maturing in 10 years would receive an annual yield of 1.82 percent. According to Morgan Stanley, the yield on an equivalent taxable bond would be 2.78 percent for a New York State resident in the 28 percent federal tax bracket. Judged against previous years, it’s not much of a return, but interest rates have been so low for so many years that investors are chasing yields in every corner of the market.

The average Thomson Reuters MMD 10-year AAA yield for the last decade has been 3.46 percent (5.28 percent for a taxable equivalent). When markets broke down in October 2008, yields went haywire and hit their 10-year high of 4.86 percent (7.42 percent for the equivalent taxable bond).

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