The argument for municipal bond mutual funds
For retail fixed-income investors, there are three main approaches to owning municipal securities: buying actively managed mutual funds, buying individual securities and laddering them to mature at intervals (see explanation below), or buying municipal ETFs like BlackRock’s MUB.
Because investors have different goals and needs as well as varying amounts of knowledge and time to research their options, there are advantages to each approach. AllianceBernstein sent over this blog post, which makes a very good argument for active management through mutual funds. It’s from Guy Davidson, the director of municipal bond management. I’m hoping to run pieces from other professionals in the next week or so advocating the other approaches.
The importance of being active: The problem with ladders
By Guy Davidson
Laddering entails buying bonds with a range of maturities and holding them to maturity. In our view, laddering has always left potential gains on the table that an active manager could scoop up, but the strategy has become especially problematic today.
Before 2008, about half of newly issued bonds came to the market as AAA-insured bonds. This made it appear fairly safe for individuals or their advisers to choose among the wide array of available bonds.
But several of the major bond insurers went out of business in the last few years after expanding into subprime mortgages tied to individual homes. As a result, only about 5 percent of bonds have come to the market with insurance so far this year, and the pool of AAA-rated municipal bonds has been dramatically reduced. Individual investors can no longer rely on a AAA rating for safety. Now more than ever you have to understand the credit particulars of the bonds you buy.
From a rates market to a credit market
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.
Further:
Municipal Analysts Group of New York: Video of speakers at luncheon meeting at the Yale Club, Feb. 17, 2012
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.
Year-end in muniland, part 1
Lots of excellent municipal bond market analysis is coming muniland’s way, and I’ll be sharing some of it through the end of the year. First up is Daniel Berger of Thomson Reuters Municipal Market Data, who makes an interesting point about the municipal bond yield curve. He notes that the 10-/30-year slope (or difference in yield on 10-year AAA bonds and 30-year AAA bonds) has rapidly steepened since August 1. Berger attributes this to the great performance of 10-year AAA bonds over that period. In a little over two months their yield has dropped from about 2.55 percent to under 2.00 percent. Investors are loving these bonds — it’s a full on “flight to quality.”
Berger next gives us a snapshot of flows in and out of municipal bond funds. After a very rough beginning to the year it looks positive going into year end:
Muni bond funds posted about $1.04bln of net inflows for the week ended December 7, according to data released on Thursday by Lipper. This was the biggest inflow since March 10, 2010, when investors put $1.13 billion into the funds. The latest week’s inflows were a sharp turnaround from the almost $298mln of outflows seen in the prior week, which was the first negative reading in seven weeks.
The four‐week moving average remained positive atabout $344mln. From early November 2010 until June 8, 2011, muni funds recorded 29 consecutive weeks of outflows. Since then,the fund flows have been mixed (but generally positive), posting inflows for seventeen weeks and outflows for eleven weeks.
And lastly, he looks into historical default data for municipal bonds:
Why the little guys can be on top
Here is a brilliant map from the Tax Foundation (via WPRI.com). The percentages on the map indicate the amount of each state’s annual budget that goes to pay off interest on their debt. Massachusetts leads the pack in this statistic with 9.58% of their budget going towards interest payments, much higher than the average. It’s important to note that this is not a map of relative ranking of debt loads as that would look quite a bit different and have California in the lead.
After seeing this map, S&P’s announcement that cities and states can keep their AAA rating despite the U.S.’s downgrade makes more sense. The National League of Cities said the following in response to Standard & Poors’ statement:
Standard & Poor’s announcement that cities and states may keep their AAA bond ratings despite the recent downgrade of the U.S. federal government demonstrates the difference between U.S. federal debt and the municipal bond market.
Unlike the federal government, municipal debt is typically not used to finance day-to-day operations. Local and state governments use municipal bonds to finance infrastructure projects. Nearly all local and state borrowing is longer-term (20 or 30 years) and debt service payments are predictable (usually the same amount each year). Additionally, local and state debt levels are low, about 16 percent of GDP, and usually representing a relatively small portion of local and state budgets, about 5 percent on average.
Reuters: Some munis can have higher ratings than US – S&P
Bond Buyer: S&P Report Says States, Locals Can Be Rated AAA
Bloomberg: S&P Plans No Added Muni-Rating Cuts Until U.S. Budget Details Are Complete
Top Ten States (highest debt) Voted for Obama
Bottom Ten States (lowest debt) – Voted for McCain
Insurers have “manageable” muniland risk
Insurers have “manageable” muniland risk
Meredith Whitney has made many assertions about muniland, but the only one that I had not heard from others before she stepped onto the national stage was her contention that insurance companies would be forced to sell their municipal bonds into a declining price spiral. She alleged this would collapse muniland, so it’s very interesting to see Moody’s assess the risk for insurance industry. From Property Casualty 360:
Property and casualty insurers remain the most exposed sector among financial institutions to volatility within the municipal-bond market, holding about $355 billion in municipal bonds, but the overall level of risk should be manageable, Moody’s says.
In a Special Comment, Moody’s says municipal bonds represent 60 percent of the industry’s equity capital base, as measured by policyholders’ surplus. This figure is down from the prior year, when the industry held about $370 billion in municipal bonds, representing about 70 percent of policyholders’ surplus.
Moody’s also says that, as part of its stress-testing of P&C insurers, it projected losses on muni-bond portfolios under both baseline and downside scenarios, and in both cases credit losses were manageable.
The baseline scenario, Moody’s explains, assumes a continued sluggish economic recovery. Under this scenario, credit losses were projected to be $300 million for P&C companies rated by Moody’s, and $500 million for the entire U.S. P&C industry over a five-year horizon.
For the downside scenario, which assumes significant credit deterioration consistent with multi-notch downgrades across the muni sector and high default rates, credit losses could approach between $2 billion and $3 billion, Moody’s says.
Insurance Journal: P/C Insurers Can Handle Muni Bond Stress: Moody’s
Reuters: Insurers can manage U.S. municipal bond risk: Moody’s
Yes, unfunded pensions are liabilities
From Bond Buyer (emphasis mine):
Muni sweeps: Muniland hits the airwaves
Change can be glacial, but it happens
Bloomberg digs a little deeper into the story of pension-fund woes and finds California municipalities are already adopting changes, with more to come:
In a survey by the League of California Cities, two-thirds of the 296 localities that responded said they’re negotiating changes in their plans. Thirty-eight percent had increased pension payments from current employees, and 20 percent had created a new tier of benefits for future hires.
Some believe the changes at the local level, particularly lower benefits for future workers, don’t go far enough.
“It deals with new hires, and right now we’re not hiring,” said John Moorlach, a supervisor in Orange County. “The only real change you can have is to go back to bargaining units” and negotiate increases from existing members, he said.
Blip blip
Chip Barnett of Reuters reports on the tiny inflow muniland-bond funds saw this week:
For the first time in over six months, investors turned bullish on U.S. municipal bond funds and poured millions of dollars back into them, according to Lipper data issued on Thursday.
Muni bond funds saw more than $274 million of net inflows in the week ended June 8, breaking 29 straight weeks of redemptions, Lipper reported. The last time muni funds had posted an inflow was in the week ended Nov. 10, 2010.
Transparency coming to private California conduit issuer
Muni sweeps: Hack for change
Attention Muniland! Do you have an idea for a public web or mobile application? Change.org is sponsoring a Hack for Change on June 18th and 19th and is soliciting ideas for their programming competition. Here are some of the ideas that have already been posted:
- A reviews site that allows citizens to rate and evaluate city government services and departments
- A site that makes government data more accessible and actionable
- An app that lists all San Francisco city legislation and allows residents to vote on it
- An app that notifies police of suspicious activity
Submit your idea today!
Muni Web 2.0 stars
Government Technology reports on the winners of a wonderful competition to create the best municipal Web 2.0 and social media technologies:
Santa Monica, Calif., was spotlighted for its XML feed that makes real-time parking information available to the public, including the number of parking spaces available in the city. The information is displayed on a city webpage with the number of spaces being updated every 60 seconds.
Arvada, Colo., received the award for its virtual city hall. Called “ASK Arvada,” the tool is designed to increase customer service by providing access to answers and the ability to request service with every department in the city. Requests can be sent through various mediums, including the Web, Twitter and smartphones.
Muni sweeps: Dirty bonds?
Dirty bonds?
Economic Musings has posted an excellent piece on “community development district” [CDD] bonds. CDD bonds, commonly called “dirt bonds,” were widely used to fund housing development infrastructure during the real-estate bubble. Needless to say, many have been hit hard due to the collapse of the housing market. Economic Musings outlines the legal and structural details of these bonds and then questions whether high-yield muni bond funds are accurately valuing the securities in their portfolio:
Lost in the implosion of the securitized markets sits an overlooked yet just as opaque remnant of the housing crisis – CDD or “Dirt Bonds”. Save for the rare fixed income aficionado, this segment is still to this day unknown. In general, a CDD is a local, special purpose government authorized by the state as an alternative method for managing and financing infrastructure required to support community development. In most cases, the community development is water, sewer, and drainage infrastructure to raw undeveloped lots. The CDD then levies assessments on the property.
These taxes and assessments pay the construction, operation and maintenance costs of the district and are set annually by the governing board of the district. The taxes and assessments are in addition to county and other local governmental taxes and assessments and all other taxes and assessment provided for by law.
Muniland revenue flows
Natalie Cohen of Wells Fargo Securities issued a research piece yesterday called “Small Issuer Focus.” There is a lot of good analysis in the piece, notably this very succinct sketch of muniland revenue challenges:
The “double whammy” of budget reductions and constrained local revenues could, in our opinion, make the coming year stressful at the local level. However, we note that the return of revenues at the state level should take some of the pressure off cuts to local government next year and afterward, particularly for schools, which are considered a high public service priority.
While state government typically relies on highly economically sensitive revenues such as sales taxes, personal and corporate income taxes, local governments depend on property taxes. Property values and more important, property assessments against which taxes are levied, are slower to reflect economic change.
Recent reports found that values continue to decline in places and may not yet have hit bottom. For these reasons, property tax revenues will likely, in our view, remain under pressure for at least the next few years as housing foreclosures slowly slog their way to resolution.
Muni sweeps: “Intergovernmental downloading”
“Intergovernmental downloading”
Lisa Lambert of Reuters writes about a report issued by Fitch Ratings. From the Fitch report:
As has been the case in past times of financial strain, states are rethinking the size, cost, and role of their governments as they develop solutions to budgetary shortfalls. In many cases, this process has resulted in decreased local government funding. The extent to which local governments will feel the impact of these actions varies based on how dependent they are on state funding.
As such, Fitch Ratings believes school districts and counties will experience the greatest funding reductions. This report addresses the relationship between state and local government issuer ratings and discusses some of the main ways in which state actions can affect local government finances.
Lambert hones in on school districts and counties:
Fitch Ratings said in a report on Friday that school districts and counties will face their greatest funding reductions from states.
It said cuts in aid can result in “intergovernmental downloading,” where the financial burden for a service is shifted from a higher level of government to a lower level.
“Even if a funding source is identified, it may prove insufficient to cover the service that needs to be provided or may not grow at the rate needed to keep pace with expenditure growth,” Fitch said.
It added that local governments may not be able to cut programs states stop funding “because of the essential nature or legal requirements of some services.” Counties provide most of these services and are more susceptible to “downloading” than cities.
States seek to escape rising prison costs
States are focusing on jails and prisons as they try to close budget gaps, reports Lisa Lambert of Reuters:
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