Muniland: the big picture (part 1)

A lot of municipal bond reporting zooms in on particular issuers or sectors and assumes that the reader understands the broader market. But the municipal bond market is foreign to most people, and I thought that it might be useful to sketch out the bigger picture. Here are some quick bullet points:

1. As of the third quarter of 2011 the size of the municipal bond market was $3.733 trillion. To put that into perspective, as of Jan. 25 there was $15.236 trillion of U.S. Treasury debt outstanding.

Source: Federal Reserve Flow of Funds (page 92)

2. Municipal bonds issued by state and local governments predominate, but there are also large amounts issued by nonprofits (think hospitals) and industrial revenue bonds (think sewer and water systems).

Source: Federal Reserve Flow of Funds (page 92)

3. Who owns municipal bonds? Overwhelmingly it is individual investors. They own 52 percent of outstanding muni debt.

Source: Federal Reserve Flow of Funds (page 92)

4. Where does demand for municipal bonds come from? Mainly, it arises from the redemption of maturing bonds and interest payments ($73 billion to individuals in 2009), which are often recycled into purchases of new bonds. In the chart below, 2011 saw fewer redemptions than usual but also much lower supply. Smaller supply increases the velocity of demand.

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.

A municipal bankruptcy does not ruin a state

Chart source: Bonddesk

State politicians in Alabama, Pennsylvania and Rhode Island have lambasted municipalities within their borders that have either declared, or attempted to declare, bankruptcy. The politicians gripe that when a municipality in their state goes into Chapter 9 bankruptcy, it affects the cost of borrowing for the state and other issuers located there. But this rests on the false assumption that markets do not discriminate between different borrowers. Municipal bond issuers, like public companies, are looked at individually because every entity has its own story. After all, when American Airlines went bankrupt, it was not as if all airlines suffered.

Alabama Governor Robert Bentley explicitly used the increased cost of borrowing for other Alabama towns as a bludgeon against Jefferson County officials who declared bankruptcy last November. The Birmingham News wrote:

He [Governor Robert Bentley] said the county’s situation already has affected borrowing throughout the state and he expects the bankruptcy to increase the cost of borrowing even more. “The credit rating of Jefferson County is terrible already so it can’t get much worse, but certainly filing bankruptcy does not help,” he said. “I know they were frustrated but at some point, you have to step up and have to be a leader and have to be a statesman and you have to do what’s right. Bankruptcy is not right.”

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).

Muniland’s most active states

In the municipal bond market, one of the most insightful ways to examine a state is to look at how actively its bonds trade. Broker-dealers make money by trading, so naturally they go where the action is and commit market-making resources to those states. It’s generally true that the most populous states are the ones with the most traded bonds, but if we map the wealth of a state’s citizens to how often that state’s bonds trade, we get some interesting results. For example, New Jersey, which has only 2.8 percent of the national population but a high proportion of its wealthy citizens, might have the highest number of municipal bond owners as a percentage of state population.

The municipal bond market does not trade on an exchange but rather on “alternative trading systems” (ATS). These are systems where dealers post inventories of bonds to be aggregated. The largest of the retail ATS is Bonddesk, which does some excellent data analysis for both the municipal and corporate bond markets.

From Bonddesk’s December Transparency Report I pulled the data for these charts showing the seven most actively traded states’ bonds. Bonddesk uses “investor buys” data, which represents trades that end up in a retail investor’s account. In the bond markets there are often many trades between broker-dealers before the securities land in an investor’s account, so Bonddesk scrubs the data to show the real level of investor demand.

Tapping the brakes on Illinois debt?

Illinois, the state in the weakest fiscal position, is planning two big bond deals in the first quarter of 2012. Next week they plan to raise $800 million in general obligation bonds to finance various transportation projects, followed by another $750 million later this winter in long-term bonds to fund construction projects.

Although the state is drowning in debt, unfunded pension liabilities and unpaid bills, these debt offerings are very restrained compared to the last two years when it borrowed to make obligatory payments to its heavily underwater pension system.

The State Treasurer, Dan Rutherford, had opposed issuing debt to fund pension obligations and managed to raise the alarm among his former colleagues in the Illinois legislature about the dangers of endless borrowing. Rutherford’s actions may have reversed the momentum of Illinois’s debt issuance. He is certainly the first fiscal officer that I have heard of who threatened to call the rating agencies to slow his state’s bond issuance.

Muniland’s public officials are clueless, not corrupt

Matt Taibbi’s latest piece for Rolling Stone, “How Banks Cheat Taxpayers,” blasts a common municipal bond market practice in which a state or municipality selects an underwriter for an offering without soliciting competitive bids for the project. These are called “negotiated bond offerings” in muniland parlance, and Taibbi likens them to a legalized form of bribery:

By “negotiated underwriting,” what Bloomberg means is, “local governments just hand the bid over to the bank that tosses enough combined hard and soft money at the right politicians.”

I really hope that Taibbi’s is making a hyperbolic statement to draw attention to his main premise that new bond offerings should done on a competitive basis, with which I agree entirely. But he implies that all state and local politicians are standing around with their hands out and are actively being bribed by Wall Street banks. If our country is that corrupt, we are in for a lot of trouble.

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.

Munis are the star performer of 2011

Bloomberg had a great piece that rounds up the factors that made municipal bonds the best performing financial asset of the past year. The story is framed as a knock on Meredith Whitney for her scare call a year ago:

This was supposed to be the year the $3.7 trillion state and local debt market would be rocked by an exploding pension time bomb and “hundreds of billions of dollars” of defaults, according to analyst Meredith Whitney.

Whitney’s Armageddon never came. Instead, munis became the star performers of 2011.

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.

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