MuniLand

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.

The SEC’s startling refresher on due diligence

The SEC’s Office of Compliance Inspections and Examinations, muniland’s uber-regulator, issued a “Risk Alert” yesterday directed at underwriters of municipal bond offerings. The alert basically said: If you offer new bonds for sale, you must perform due diligence on the issuer. And you better document what you did.

I have to wonder about all the sudden fuss. The SEC’s “Risk Alert” was just restating a fundamental law in securities markets that requires securities dealers to investigate and verify what they are offering to investors. In other words, dealers must know their product, because there is no immunity for selling bad stuff. It’s a little shocking that the SEC has to remind securities dealers that they are required to do due diligence, but they went further and detailed some specifics on what had to be done (Page 3, emphasis mine):

the Commission also stated that sole reliance on an issuer will not suffice in meeting an underwriter’s “reasonable basis” obligations.

The birds’-eye view of muniland

My Thomson Reuters colleague at Municipal Market Data, Daniel Berger, published an excellent report on the debt of the 40 poorest U.S. cities. His work is exclusively for MMD subscribers, but I excerpted the high-level part where he summarizes the general view the credit rating agencies have about municipalities. Here is what Dan had to say:

Moody’s

According to a recent report from Moody’s, the outlook for various… local governments remains negative. It cited a weak national economy and possible global risks to stock markets that could hurt state revenue. Another problem is the austerity measures of the federal government, which diminish any chance of more stimulus aid. This week Moody’s released the results of a default study of municipal bond issuers using default data from 1970 through 2011. They believe that revenue bonds will account for most of the troubled issuers and they foresee a “very small but growing number” of local government issuers defaulting on their debt.

Fitch

Fitch has no single outlook for the local governments. However, localities face two big concerns. First, Fitch expects an inflation-adjusted 13% decline in property values. Taken together with the fact that assessments are catching up with previous declines, Fitch expects further declines in property tax revenues for local governments. These declines may pressure some local bonds.

An open letter to Puerto Rico Governor Fortuño

Dear Governor Fortuño:

I wanted to write you to discuss the condition of Puerto Rico’s economy and its municipal debt load. After I wrote a column last week entitled “Puerto Rico is America’s Greece,” I was surprised to see the piece get a lot of attention. What I said has been common knowledge in the U.S. bond market for some time, and the facts that I brought up have been previously pointed out by the major credit rating agencies. For those in municipal bond markets, I wasn’t really adding much that was new to the conversation.

But it turned out the attention my piece was getting was from people outside the bond market. Those who were responding to it were those who love Puerto Rico and are concerned about its future, namely its citizens. They seized on what I wrote and passed it around on Facebook. Newspapers like elnuevodia.com and blogs picked it up and debated the fine points of the island’s unemployment rate and deficit spending. I’ve never seen anything like it in the United States.

Now, before going any further I need to mention that I made one mistake in that piece, which I did not discover until I read the rating agencies’ reports about the commonwealth. Your constitution requires that bond principal and interest be repaid before your government can make any other expenditures. That means bond repayments take precedence over payments for education, healthcare, government-worker wages and pensions. Bond markets cheer for this, of course, but I’m not sure that your citizens are entirely aware of it. Michael Corkery of the Wall Street Journal also wrote about your bond offering last week and didn’t mention the seniority of payments that makes your debt so appealing to investors.

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.

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.

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