Three good books on muniland

The municipal bond market is an arcane topic that receives little attention from the mainstream media or the academy (there are not many sources of complete information online, either). Fortunately there are several new muni books that are miles ahead of the thick tome that was previously lauded as the industry must-read: The Handbook of Municipal Bonds, part of the Frank Fabozzi series. Weighing in at over 900 pages, the Fabozzi book is best left for advanced muni market participants.


The Fundamentals of Municipal Bonds

Written by Neil O’Hara for the Securities Industry and Financial Markets Association, Fundamentals is being used as the textbook for the “Muni Bond School” that SIFMA and the New York Municipal Bond Club are conducting now. It’s an excellent general primer on the market.






Bloomberg Visual Guide to Municipal Bonds

Longtime muni industry leader Robert Doty has authored a wonderful, visual primer on muniland that blends information about the bond types and pricing and trading conventions with notes on muni tax exemption and regulation. Doty’s book is geared toward investors. It’s colorful and a lovely size to hold in your hands (approx 8 in. by 12 in.). Its only drawback is that it is heavy on the Bloomberg terminal screenshots, which are only available to professional Bloomberg subscribers. Otherwise the book is a delight.


Encyclopedia of Municipal Bonds: A Reference Guide to Market Events, Structures, Dynamics, and Investment Knowledge

The king of muniland, Joe Mysak, has written the definitive glossary of municipal bond terms. This is not a compendium of quick answers about complex subjects. Mr. Mysak takes his time describing the generalized legal meaning of a term and then gives color on market background and practices. His definition of “escrowed to maturity” bonds, for example, is eight pages long. If you are going to work in muniland or self-direct your muni investments, this would be excellent reading and the perfect reference book with a long view.

End municipal tax exemptions for private projects

There is a very blurry line in muniland between truly public activities and private activities that allegedly have some public good, and into this ill-defined space, for-profit and non-profit organizations have found ways to issue tax-exempt municipal bonds. This gray area should be a prime target for Congress to examine when it goes looking for ways to raise more tax revenue from muniland.

It’s easy to find these quasi-public projects. A quick look at the listing of today’s new bond offerings on EMMA immediately produces this $29 million bond offering at the private Rollins College in Florida to fund the renovation of its science center, campus center and one of its residence halls. There is an additional $15 million bond offering at the college to refund bonds previously issued at a higher interest rate. These bonds are being issued through Florida’s Higher Education Facilities Financing Authority, which is acting as public conduit for the private school. Rollins, an exclusive southern college, charges $50,400 per year for tuition, room and board. At these tuition levels it’s hard to see how much good the general population receives.

A more egregious example in today’s muniland bond offerings is the remarketing agreement for $14 million in bonds issued for Koch Industries subsidiary Georgia-Pacific to acquire and construct solid waste disposal facilities in the Parish of East Baton Rouge, Louisiana. In the case of the Koch bonds, the conduit authority is the Industrial Development Board of the parish. Koch Industries is not some small fish — just last year Forbes listed it as the second-largest privately held company in the country with estimated annual revenues of $100 billion.

Muniland needs defenders when Meredith Whitney talks her book

Yesterday DealBook announced the dreariest news possible for muniland: Meredith Whitney is publishing a book entitled Downgraded: Why the Next Economic Crisis Will Be Local, which is due out in November. DealBook says:

In the book, Ms. Whitney — who shook [municipal] bond markets with a 2010 appearance on “60 Minutes” in which she predicted scores of municipal defaults –will “reveal why America’s cities and states are in deeper trouble than is commonly realized,” according to the publisher.

The truth is that when Whitney made her infamous muniland prediction, she spooked retail investors into fleeing the municipal bond market in droves. These investors suffered tens of billions of dollars in losses, thanks to her.

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.

2.5 million muni bond investors unaffected by proposed tax changes

In his budget for fiscal year 2013, President Obama has resurfaced his proposal from last September to reduce the tax exemption for the wealthiest municipal bond investors. This tax reform proposal is unlikely to pass this year, but a battle is already raging in the media about what damage the change could do. Dire predictions of much higher yields for municipal bond issuers are being thrown around with little or no verification.

Even if this proposal did pass this year, muniland would not be disrupted. In fact I think it could democratize the municipal bond market in a big way. There are more than 2.5 million investors who own municipal bonds and would be unaffected by the proposal. It’s true that yields could rise a bit as the wealthiest investors exit the market, but this would just make muniland more attractive for the less affluent, since they would still be able to utilize their tax exemption. Rich investors would lose, but middle- and low-income municipal bond investors would gain.

Here are the specifics of the proposal from Market News International:

The administration is proposing to “reduce the value of itemized deductions and other tax preferences to 28% for families with incomes over $250,000.”

What happens to muniland in 2012?

It looks like smooth sailing for the municipal bond market in 2012, according to three senior market participants who exchanged views at the Fitch Ratings 2012 Municipal Credit Forum. Continued strong demand for municipal bonds, ongoing low bond issuance, favorable Federal Reserve rate policy and major banks upping their direct loans to municipal entities will make 2012 another strong year.

Estimates of how many new municipal bonds will be issued in 2012 ranged from $300 billion to $350 billion. George Friedlander, a municipal strategist at Citigroup, dug a little deeper than the gross numbers and discussed the maturity profile of the municipal debt market. He talked about “bond years outstanding,” which is a new concept to me. Friedlander explained that with the massive amount of bond refundings that are happening in this low-interest-rate environment, the overall maturity of bonds outstanding is contracting. Or, to put it another way, as municipal bond issuers call long maturity bonds, they are replacing them with shorter duration bonds at lower interest rates. This shrinks the amount of bonds available in the 15-30-year range. It could help explain the new lows that the Thomson Reuters MMD AAA scale keeps hitting for longer maturity bonds. Friedlander had estimated that there was $90 billion more in bond refundings in 2011 than new issuance.

Given that refundings took up a big portion of 2011 bond issuance, Friedlander projected that there was $170 billion of “new money” that flowed into muniland last year. Much of the cash invested in the muni space was “old” money that investors had from their refunded bonds. This would help explain the meteoric performance of muniland in 2011, and it’s likely to have big implications for 2012.

Muniland: the big picture (part 2)

Last week I wrote about the size of the municipal bond market and the kinds of investors who are involved in it. This week I thought it would be helpful to explain how municipal bonds are traded.

Most people understand that stocks are traded on exchanges but bonds aren’t. Although bonds could easily trade on an exchange (the New York Stock Exchange already has a setup to do just that), they currently trade “over-the-counter,” meaning that brokers contact each other and trade bonds between them.

This method of trading between dealers can happen on a phone call or fax, through the messaging system of a Bloomberg terminal or through an aggregator platform. These aggregator platforms are very common for fixed-income trading. The SEC publishes an updated list of trading platforms, which are known as “alternative trading systems” (ATS). The regulatory oversight of ATS is very limited when compared with exchange oversight, and they are not required to publish their rulebooks as exchanges are.

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).

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.”

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