Where are muniland’s cross-over buyers?
It’s an odd moment in muniland. There is an irregularity in the pricing of municipal bonds. Generally muni bonds have a lower yield than U.S. Treasuries because munis give investors a tax advantage. Investors use them to shield their investment income since coupon payments on municipal bonds from their state of residence are generally triple-tax-free — that is, they are not taxed at the local, state or federal level.
In this Bloomberg video Timothy Pynchon, a portfolio manager at Pioneer Investment Management, talks about how 30-year muni bonds are trading at 105 percent of the value of the 30-year Treasury. These bonds would usually trade at less than 100 percent of Treasuries because of their tax advantages. This is a very unusual situation and would usually attract so-called “cross-over” buyers from other parts of the bond market. In the video, Cumberland Advisors’ David Kotok suggests that since U.S. Treasuries are mispriced (too expensive with low yields as a result of a flight to quality) it’s having a carry-over effect for long-dated municipal bonds. Basically the long end of the municipal bond market has moved away from its normal pricing relationships and is cheap relative to Treasuries.
Further:
Bloomberg: Colorado Refunds Transport Debt as Yield at Lowest Since 1994: Muni Credit
Bond Buyer: Muni Funds See Outflows for Fifth Straight Week
“What we had here was a wholly corrupt situation”
Smooth sailing in muniland
Lately a lot of big waves have washed over muniland. The national economy has slowed; the 2009 federal stimulus program to the states has ended; there have been loud headlines about bankruptcy cases in Jefferson County, Alabama and Central Falls, Rhode Island; and Standard & Poor’s downgraded the debt of the United States with potential effects on the borrowing ability of states and municipalities. It’s a laundry list of woes.
Considering all the strong forces facing muniland it’s interesting that the municipal bond market is still in such good shape and that interest rates on municipal bonds have remained low. There are two big reasons for this performance.
The first and biggest reason for smooth sailing is that muniland’s sister market, the U.S. Treasuries market, is having a tremendous rally as investors sail into the safe harbor of owning U.S. debt. Even though Standard & Poor’s downgraded U.S. debt to AA+ two weeks ago the U.S. Treasury market is both liquid and deep; it provides investors with security and a place to park assets. There has been so much demand for U.S. Treasuries that their yield (which moves in the opposite direction of the bond price) is nearing the ultra low yields of Japanese government debt. Bloomberg reports:
“We are beginning to resemble Japan from an interest-rate policy standpoint as well as potentially an economic growth standpoint,” Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said in a telephone interview Aug. 10. Investors are “fearful of low growth and are fleeing to high-quality sovereign paper at whatever yield.”
Investors’ flight to quality in the face of uncertainty benefits the muni market and helps create strong demand for municipal bonds. Numerous Wall Street dealers have also reported foreign investor demand for U.S. municipal bonds as U.S. Treasuries yields have moved so low.
Another big reason for the positive muniland environment is that new muni bonds are coming to market at about half the rate of last year. You can see the data in the chart above. July’s new issuance is running about 40% of last year. States and municipalities are borrowing much less and muni bond supply is contracting. Borrowers have scissored their muni credit lines and are postponing projects. Thomson Reuters Municipal Market Data characterized supply like this (emphasis mine):
Continuing wills for the United States?
The theatrics in Congress concerning the debt ceiling, now in their seventh month, have sent increasingly strong shock waves throughout the U.S. and global financial systems. The debt ceiling is the legislatively-imposed limit for the nation to issue debt to fund its activities. It’s been stalled at the same level of $14.3 trillion since May 16. The U.S. Treasury has been scrambling to find extra monies, including borrowing internally from the federal government workers’ pension plans, so that they can continue to pay the nation’s obligations. They say the cash drawer is near empty.
The United States borrows or issues debt for 40 cents of every dollar that it spends — that is a lot to borrow. The federal government turns around and distributes this borrowed money, along with taxes collected, to Social Security and Medicare beneficiaries, states and local governments and defense contractors. It also returns some of it to bond holders as interest payments. The federal government is so massive that this flow of payments equals about 24% of the gross national product. If this flow stops, substantial parts of the economy will stop.
Organizations that oversee, or participate in, the financial system are rightly concerned. One positive benefit of these long, drawn-out Congressional deliberations is that there is time for extensive planning and analysis. Credit rating agencies have particularly been concerned with the downstream effect on state and local governments. Today Moody’s issued a press release that affirmed the strong AAA rating of 400 local governments while saying it would review the AAA rating of 162 other local governments (emphasis mine):
The review for possible downgrade affects 162 Aaa-rated local governments and $63 billion of debt. Factors weighing on specific credits include high federal employment and exposure to capital markets disruptions.
The 162 local governments include 66 cities, 53 counties, 29 school districts and 14 special tax districts. The local governments are located in 31 states, with the heaviest concentrations in Virginia (15 credits) and Massachusetts (14 credits).
Moody’s is creating a map of the effects of a downgrade of the U.S. government. They’ve identified their main concern as areas where there are heavy concentrations of federal employment.
Similarly, the Federal Reserve and other bank regulators are preparing instructions for financial institutions in the event that the U.S. Treasury halts payments. Reuters reports:
Markets hold the whip, but are they rational?
There has been a lot of discussion over the past few days about whether the United States deserves a triple-A rating. The weak and meandering attempts of the Congressional leadership and President Obama to reach a consensus on raising the debt ceiling has prompted this storm of confusion. The political theater is painful.
Most of the talk about ratings revolves around whether the level should be lowered one or more notches. But in The Telegraph today Ambrose Evans-Pritchard goes further and says it’s not really that important whether the United States retains a triple-A because the credit rating agencies don’t have the credibility to strip the rating to the world’s largest sovereign debt issuer (emphasis mine):
Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.
Evans-Pritchard’s statement implies that the qualitative judgments of rating agencies about default risk are less useful than the collective insight of bond-market participants. But is the market rational? The bond markets assess their view of the likelihood of default through a quantitative measures like credit-default swaps. CDS are bought and sold between institutional investors and represent a sort of wager on whether an issuer like the United States or the state of Illinois will default on its bonds. They are a kind of insurance policy because if the issuer does default then the holder of the CDS receives payment of principal from the issuer. In other words, it’s an opinion with a whip in its hand — unlike the assessments of credit rating agencies, whose raters suffer nothing if they assigned the wrong rating.
The CDS market data provider, Markit, sent over some price levels on municipal CDS today that included a price for CDS on U.S. Treasuries. I thought it might be interesting to compare the credit rating of the US (AAA/Aaa) and the corresponding credit-default swaps (in basis points) against some heavily indebted states (see chart above).
What we see is that although the federal government has over six times the amount of debt relative to what they collect in tax revenues, they receive a AAA rating and 58 basis points on 5-year CDS. This is quite low when compared to Massachusetts, which has a AA/Aa rating (two notches below AAA) and 107 basis points on their CDS.
This beneficial treatment for the debt of the U.S. government has persisted for a number of years. The difference between the very low cost of insurance for the United States and the higher costs for the states is always explained away by saying the federal government can simply print more money; it can’t default because it has an endless money supply.
Muni sweeps: Clouds for pretty Puerto Rico
Happy days may be over in our 51st state. Joan Gralla of Reuters reports:
Puerto Rico’s credit rating might be cut due to its “deeply underfunded” pension system, Moody’s Investors Service said on Tuesday, in a reminder of one of the biggest threats to state and local finances.
Puerto Rico now is rated A3 by Moody’s; about $28 billion of debt issued by the Commonwealth was affected by the warning from the credit agency.
Puerto Rico’s financial problems are not only deep but long-standing. Moody’s cited years of over-estimating revenues, underestimating expenses and relying on deficit borrowing.
Much of Puerto Rico’s debt is widely held throughout the United States because investors do not have to be residents of the Commonwealth to capture its tax-free returns.
The credit agency estimated Puerto Rico’s unfunded pension liability at $24 billion. The Commonwealth also must repay $42 billion of debt backed by taxes. Adding those two liabilities together produces an amount that is seven times the annual budget, Moody’s said, calling this “a combined burden that will exert significant budgetary pressure for many years to come.”
Photo: South view of the Capitol of Puerto Rico building, located in San Juan, Puerto Rico. Wikipedia.
Wyoming climbs to the top rung
From Bloomberg:
Wyoming’s general-obligation debt rating was raised one step by Standard & Poor’s to AAA, the highest investment grade, as the firm cited the state’s “conservative budgeting and forecasting practices.”
Wyoming, the least-populous state, joins 11 others with top credit ratings from S&P. The company said Wyoming’s outlook is stable.
Wyoming’s Powder River Basin holds the largest and least- expensive coal reserves in the U.S. The state provides almost 40 percent of the domestic coal used to generate electricity last year, according to the Interior Department. Governor Matt Mead has said he hopes to attract other industries to the state.
-
Resident Muniland expert
-
