Winners and losers in a hot municipal market
Like U.S. Treasury debt, muniland securities have been hot, hot, hot. Investors have been piling into municipal bonds for about 16 consecutive months. At first, demand was driven by investors who were attracted to the high yields in the wake of Meredith Whitney’s predictions of default, which scared retail investors out of the market between November 2010 and February 2011. Demand then accelerated as the Federal Reserve kept interest rates at artificially low levels, driving investors out of Treasuries and into riskier assets. Steady municipal bond mutual-fund flows, coupled with the reinvestment of muniland proceeds into new bond issues, has also helped keep demand elevated.
On the supply side, municipal bond issuance in 2011 slowed to $295 billion, down 32 percent from 2010 and the lowest level since 2001. This lack of supply, along with massive demand, has covered over a lot of issuer weaknesses that would normally drive yields higher. Bloomberg reports:
“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.
One of the beneficiaries of this dynamic has been California. Its bonds have been enjoying strong demand even as the governor announced larger-than-expected deficits last week. Bloomberg said:
The extra yield on issues from California, the lowest-rated U.S. state by Standard & Poor’s, fell to 0.82 percentage point [82 basis points] last week, matching the smallest since December 2008, according to data compiled by Bloomberg.
Although the market has tremendous momentum, some issuers are being left out. For instance, investors are wary of Illinois debt, which has averaged 160 basis points over the last year. Another one of the laggards is Puerto Rico. As seen in the chart below prepared by Daniel Berger of Thomson Reuters MMD, the spread of Puerto Rico’s debt over the MMD AAA benchmark has remained relatively flat over the last year, hovering around an average of 219 basis points.
What we’ve learned from municipal distress
This is a guest post from Joe Rosenblum, the director of Municipal Bond Credit Research at AllianceBernstein.
Is the municipal bond market on the verge of collapse? You might think so, given the blaring headlines about a few big disasters in the last year. But the truth is that poor decision making, not systemic issues, has caused the most serious problems.
Jefferson County, Alabama, and Vallejo, California, filed for Chapter 9 bankruptcy protection. Receivers were appointed for Central Falls, Rhode Island, and Harrisburg, Pennsylvania. Stockton, California, is deferring debt-service payments (though bondholders continue to get paid from other sources) as it goes through a state-authorized mediation process with its creditors. And most recently, Detroit agreed with the State of Michigan on a shared fiscal oversight process to avoid bankruptcy.
There is no question that state and local governments are facing financial hardship as a result of the weak economic recovery and its impact on tax receipts. But this is not the first time local governments have been challenged or have defaulted on their debt or filed for bankruptcy protection.
In the 37 years since New York City’s brush with default in 1975, there have been a slew of other bankruptcies, defaults and near-defaults. Prominent among them were cases involving the Washington Public Power Supply System (WPPSS); Cleveland, Ohio; Bridgeport, Connecticut; Yonkers, New York; Erie County, New York; and Orange County, California. All of them also grabbed headlines in their day.
Here are some lessons we learned from them:
- Municipal bonds are not risk free
Buying individual bonds
I’ve previously featured a guest post about the advantage to retail investors of buying municipal bond mutual funds. Retail investors can also directly buy individual municipal bonds. This is a tiny part of muniland, but I could see it growing in the future. Today, I welcome a guest post from Andrew Wels, the head of retail fixed income and vice-president for retail at E*Trade Securities. Wels writes about the advantage of buying individual bonds and “laddering” them.
Buying individual bonds by Andrew Wels
Most financial professionals would agree that a mix of stocks and bonds is essential to a well diversified portfolio. Stocks provide growth potential, and bonds offer both regular income and return of principal upon maturity. Many individual investors are familiar with selecting stocks, but bond investing tends to be viewed as more complex.
Bond funds vs. bond ladders
A bond fund, an investment in a portfolio of individual bonds, is a popular investment vehicle for accessing the fixed-income markets. Bond funds offer diversification and some characteristics of the underlying individual bonds in which they invest. Unlike individual bonds, the interest income from a bond fund is not fixed, so there is no fixed maturity date. For the past several decades, declining interest rates have generally boosted the net asset value of bond funds. Consider the inverse: When interest rates rise, bond fund values tend to decline, exposing an investor’s principal to risk.
In a period of rising interest rates, investing in a ladder of individual bonds and holding them to maturity can help mitigate the principal risk inherent in investing in a single bond. A bond ladder is a diversified portfolio of individual bonds with staggered maturities. At each interval, a portion of the bonds in the ladder mature, and the proceeds may be reinvested at the then-prevailing interest rates, which may be higher or lower than the original rate, or used for other purposes.
Muni exchange traded funds
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A small but growing corner of muniland consists of municipal bond exchange traded funds (ETFs). I know very little about these products and asked Matt Tucker, a managing director on BlackRock’s fixed income portfolio management team, to write a short introduction to the product.
ETFs: The new way to access the municipal bond market
Traditionally, the only two options available for those who wanted to invest in the municipal bond market were through mutual funds or laddered bond portfolios. In the past five years, though, exchange traded funds (ETFs) have come on to the scene. They provide a combination of diversification, index performance and exchange liquidity, making them a compelling addition to anyone’s municipal bond investments.
Like other funds in the market, ETFs offer diversification, a challenge to achieve for individual bondholders. Bonds generally trade in lots of 10,000 par or more, making it difficult for all but the wealthiest investors to build good, diversified portfolios. The share of the muni market that was AAA-rated fell from 70 percent in 2007 to 15 percent today, as a result of the demise of the bond insurance companies over the past few years. As a result, there is much more default risk in the current market. Muni ETFs generally hold hundreds of positions, and shares of the ETF can be obtained for the price of a single share of a single fund, often as low as $50. Like individual bonds, the holdings are visible, meaning that most ETF providers allow investors to see fund holdings on a daily basis. This provides investors with the comfort of knowing what they own.
In terms of performance, the majority of municipal bond ETFs in the market are index funds. According to a Standard & Poor’s study released at year-end 2011 that examines the performance of active funds, 90 percent of national municipal bond funds underperformed their benchmarks over the past five years. Index ETFs are generally not the highest-performing funds in a given period, but they have also not been the lowest. This can make them a compelling alternative for investors looking for more consistent performance in their municipal bond portfolio.
Thanks. Gotta love the efficient markets debate; one of the angels on the head of pin discussions for our time.
A smarter way for Congress to talk about muni tax code
Chris Mauro, head of U.S. municipal strategy at RBC Capital Markets, sent around a comment note suggesting that the media coverage of the Senate Finance Committee hearing Wednesday that included discussion of possible changes to the taxation of municipal bonds was overheated:
Yesterday, the Senate Finance Committee held a hearing entitled “Tax Reform: What It Means for State and Local Tax and Fiscal Policy”. A simple reading of the media accounts of this hearing would lead one to believe that the entire event was dedicated to a detailed discussion of the future of the tax-exempt status of municipal bond interest. So we decided to review the tape of the hearing in order to see what in fact was discussed. In reality, the vast majority of the hearing was focused on two issues – the deductibility of state and local taxes by federal taxpayers and the ability of state and local governments to collect sales taxes on internet and catalog purchases.
Both Committee Chairman Max Baucus and Ranking Member Orrin Hatch made some passing comments about tax-exempt bonds and the federally subsidized taxable Build America Bond (BABs) program, with Baucus making generally positive statements about BABs and Hatch making generally negative ones. Senator Maria Cantwell of Washington State expressed some concern about the importance of tax-exempt bond financing to public power utilities in the northwest, but beyond that, there wasn’t a whole lot of discussion about the muni tax exemption.
In our view, the biggest take-away from the hearing was just how far away we seem to be from a comprehensive tax reform package actually becoming reality. We found it informative that at several points during the hearing, Senator Baucus discussed the difficulty Congress has in identifying which tax expenditure items need to be cut in order to lower overall tax rates, asking the witnesses during one exchange to contribute some creative ideas in that regard. This confirms something that the market already knows but needs to be continually reminded of – real comprehensive tax reform is extremely difficult to pull off and will take a considerable amount of time to accomplish.
I didn’t watch the hearing but it sounds as if RBC’s Mauro read the tea leaves pretty well. I’m sure that Congress is having difficulty identifying where to amend the tax code to make it fairer and raise additional revenue or have revenues remain neutral. The deliberative congressional process gives all the issue’s players a chance to be heard, and tax matters are often the most fiercely fought. But the other thing I noticed in Mauro’s note was that Congress is looking for new ideas to address this complex issue.
One idea that I’m interested in is having Congress more narrowly define what constitutes a “municipal bond” issued for the public good. In muniland there are a lot of private activity bonds that do not provide infrastructure or services for the general public but rather for a select audience that must pay substantial amounts to gain access. The tax-exempt bonds of “non-profit” hospitals offer the most obvious example, as I wrote several weeks ago:
As the legislative and executive branches thrash out the exact standard for how much charity care a hospital must provide, the deeper issue of for-profit entities using most of the physical space in a tax-exempt, non-profit building needs more attention. The original county review that sparked Illinois to look more closely at non-profit hospitals, that of the Provena Covenant Medical Center, detailed the extent of for-profit activity in the system:
“Provena Covenant Medical Center allows outside, for-profit entities to use the facilities to generate personal and/or corporate profit. There are multiple outside physicians’ groups and service providers who use the hospital to serve patients. These physicians’ groups are for-profit entities that practice in the hospital and then bill patients for work done in what is claimed as a tax-exempt property…”
I’ve also written about Exxon Mobil and Koch Industries, which have tax-exempt bonds for refinery facilities and waste treatment plants, respectively, in Louisiana. As Congress thinks about creating greater fairness in the tax code, the tax exemption for private activity bonds is one place to look, and I’m sure there are other areas where changes could be made.
Does the market trust corporate issuers more?
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 Nelson @BNels22 you can blame tax-exemption, serial bond structure, poor disclosure for #muniland yield disparity http://bloom.bg/IaZB8t
After this blog post appeared Bob Nelson tweeted out:
@cate_long investors just know them better – better disclosure. #muniland
To be continued…
Municipal bonds don’t always have the best after tax returns
The following is from guest commentator Terry Hults, Senior Portfolio Manager of Municipal Investments, at AllianceBernstein. It’s helpful to see municipal bond investing in a broader light and the data above really frames the discussion well.
Municipal bonds have an after-tax yield edge over Treasuries, corporates and other taxable bonds most of the time—but not always, as the display above shows. Opportunities are driven by sector supply and demand, credit-quality trends, volatility, and changes in tax law. Treasuries did best in 2007 and 2008, corporates did best in 2009, and mortgages did best in 2010.
Adding a judicious allocation to these taxable sectors during those years would have meaningfully added to the returns of a tax-aware portfolio. Today, low interest rates and the fear of future rate increases have driven some bond investors into shorter bonds and cash. But an investment strategy that considers municipal and taxable bonds across the full credit spectrum provides greater ability to pursue return without taking undue risk.
It’s true that as the economy improves in the months and years ahead, the impact of rising interest rates will be felt on bond portfolios. But higher-yielding corporate and municipal bonds are much less sensitive to interest rates and typically perform better than lower-yielding municipals (and treasuries) in a rising-rate environment. That’s because their higher yields provide more of a cushion, and the fundamentals of the borrowers tend to improve with the economy. As the economic cycle shifts and rates rise, investing across sectors should help safeguard portfolios.
Boston funds publicly, while Chicago goes private
Two major American cities are embarking on large capital programs, but in very different ways. Boston Mayor Thomas Menino has a $1.8 billion, five-year plan that he will fund with municipal bonds, while Chicago Mayor Rahm Emanuel is trying to push a $7 billion plan, which will be paid for by private investors, through the city council. It would be hard to find to two more dissimilar approaches to rebuilding America’s urban infrastructure or two more different lists of who will reap the monetary benefit of the improvements.
Boston approaches its infrastructure needs with a rolling five-year schedule of projects that is updated on an annual basis. This allows for more controlled expensing and planning. In contrast, Chicago’s Emanuel announced his infrastructure privatization plan in January with very few details and buy-in only from the private investors who will benefit from their involvement. The Chicago proposal gives control of infrastructure decisions to a panel of four private citizens and one city council member with no ability for the city council to have oversight on projects and contracts. Chicago has a terrible history of leaving taxpayer money on the table in its privatization efforts. In 2008 the city’s parking meters were leased out to private investors for a tiny sum:
Chicago drivers will pay a Morgan Stanley-led partnership at least $11.6 billion to park at city meters over the next 75 years, 10 times what Mayor Richard Daley got when he leased the system to investors in 2008.
Morgan Stanley, Abu Dhabi Investment Authority and Allianz Capital Partners may earn a profit of $9.58 billion before interest, taxes and depreciation, according to documents for a $500 million private note sale by their Chicago Parking Meters LLC venture. That is equivalent to 80 cents per dollar of projected revenue.
Chicago, with a population of 2.7 million, is over four times larger than Boston, with 617,000 residents. But Boston will be spending about $2,900 per resident compared with Chicago’s $2,597 without privatizing any of the work. Boston does have lower funding costs because it is viewed more favorably by bond markets, with a rating of Aaa from Moody’s, its highest rating. Chicago comes in three notches lower at Aa3, or what Moody’s terms “high quality and very low credit risk.” Bond markets do make Chicago pay more, and its bond* due 2024 traded at 3.32 percent Thursday, while a comparable Boston bond,** due 2024, traded at 2.28 percent, according to the Municipal Securities Rulemaking Board’s EMMA system.
The additional 1.04 percentage points Chicago pays to borrow versus Boston is a much lower cost for Chicago than what it will pay to private investors through Mayor Emanuel’s proposed infrastructure trust. America’s urban areas need revitalization, but taxpayers should not have to transfer the benefits of their city’s rebuilding to private investors. Boston Mayor Menino has the right approach and should be a model for Chicago Mayor Emanuel.
The Marlins’ new home, courtesy of taxpayers
Kevin Grey of Reuters wrote a delightful piece describing the opening of the the new home of the Miami Marlins. The stadium has all the touristy bells and whistles that you would expect from a state that brought us Walt Disney World, Universal Studios and Sea World:
When baseball’s Opening Day kicks off next week, the Miami Marlins will inaugurate a new $515 million ballpark built with all the trappings of South Florida – two enormous fish tanks, palm trees and a kitschy (of course) home run celebration display.
With all its fancy trappings, the Marlins’ new stadium could very well set the national standard for family-friendly sports destinations. But after the opening-day fireworks dissipate, it will become clear that the ballpark sets a low bar for public diligence and oversight and that it could result in an SEC sanction (or worse) for some local public officials.
Officials at the county and city level agreed to pay for 80 percent of the new stadium without holding a public referendum or examining the financial condition of the team. The Miami Herald reported as much last December (emphasis mine):
Long before the deal to build the Marlins a new ballpark in Little Havana was cemented with a county commission vote in March 2009, the deal was ridiculed as lopsided, with critics complaining that elected leaders kowtowed to a wealthy ballclub owner threatening to leave town. In the end, the Marlins got their way.
The 37,000-seat, retractable-roof stadium ended up being a top-heavy deal for the county, put on the hook for $347 million in construction bonds, a $35 million loan to the Marlins, and $12 million for incidentals such as road repairs. The city’s end of the deal is $94 million worth of parking garages, $13 million toward construction, and $12 million for other improvements.
The county will have to dish out more than $2 billion over 40 years to pay back the principal and interest on the bonds, which were sold under poor market conditions.
The ballclub – which receives virtually all revenues, from concessions to ticket sales for everything from ballgames to soccer matches to concerts – was required only to spend $120 million at the end of construction, on top of repaying the loan to the county in $2 million yearly installments that would serve as rent.
Attention public officials: Giving away hundreds of millions of dollars of taxpayer money to wealthy sports owners is not acting in the best interests of the public. According to Moody’s, Miami-Dade County has “ongoing depressed economic conditions.” Although the stadium is sure to provide many families with some good times, it is going to require a lot of other families to pay taxes to pay off its bonds.
Animated gif of the home run display…
http://cdn2.sbnation.com/imported_assets /1032676/boosh.gif
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.
Source: Municipal MarketData, Moody’s Investors Service, Standard & Poor’s Ratings Services, local government budget reports, official statements.
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Resident Muniland expert
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