Thursday, August 1, 2013

Muni Bond Market Troubles – What You Might Like to Know

As the news feeding frenzy has begun to focus on the $18B Detroit bankruptcy filing on July 18, 2013, it is time for investors who have exposure to the market, or are thinking about taking on new positions to get a better understanding of what is happening in this game.   There are countless headlines about the impending doomsday for municipal bonds driven by the underfunded pension system for public workers in many municipalities across this country.   I would say that this is not really new information, but it does make good conversation.  But, this conversation is impacting the market, so it is a good idea to understand why, and whether you should be bailing out before financial Armageddon, or looking for opportunities that are being created by the fear mongers.

The confusing part for investors is whether they should view Detroit in isolation, or as a systemic indicator.  Meredith Whitney is a good example of someone in the systemic camp.  In an interview with CBS news show 60 Minutes in December of 2010 she made the sweeping call: "You could see 50 size-able defaults - Fifty to 100 size-able defaults.  More. This will amount to hundreds of billions of dollars' worth of defaults." (Meredith Whitney December 2010 Interview).  With the Detroit bankruptcy now making headlines on a daily basis, Meredith is back in the news with the same information (Wall Street’s Meredith Whitney: ‘The thing for me is being right’ – July 2013).   I don’t recommend making investment decisions based on another person's ego. 
  
What is really going on in the market, and how is the municipal bond market priced relative to the risk involved?   This is the type of information that needs to be understood in order to make good investment decisions about municipal bonds.  I have not found a lot of financial news directed at this question. 
This article pulls together data  on the pricing of the municipal bond market dating back to 1953.   The information is reviewed relative to the long-term Treasury bond market, the proxy for the lowest risk-free interest rate which is most comparable to the 20 Yr Municipal Bond Market Index.  Given the historical data, the article then turns to the question of how has the pricing changed given the changing market conditions and information in the news.  What is most interesting to me, and possibly it will be to you as well, is that market pricing has already changed dramatically in recent years relative to alternative investments.   The market is functioning very well to price the potential for added default risk now evident.  So, it is very possible, short of the doomsday scenario, that the current analyst grandstanding might once again be flushing investors out of good investments out of fear rather than sound risk assessment.  

Municipal Bond Interest Rates Historically

The municipal bond market dating back to the early 1950s has historically had one major characteristic, it has been priced at an interest rate below the comparable Treasury bond maturity - a negative spread.   The starting point for the graph below is 1953, which in the context of the history of interest rates is important because it is post the 1951 Treasury – Federal Reserve Accord, a point in time in which the Depression era pegging of interest rates ceased and the long-term rates were generally set by the free market. 


The average 20 year maturity GO Municipal Bond from 1953 through 2007 was priced at 100 basis points below the 30 year Treasury bond.  Of course, there has been fluctuation in the spread through time.  The low rate era of the 1950s was a time period of tighter spreads.  As federal tax increases ensued in the 1960s and 1970s, and interest rates moved higher due to rampant inflation, the spread widened.    But the spread remained consistently above zero through-out the time period until the end of 2007.  In fact, there are only 6 monthly observations in the entire monthly data history from 1953-2007 that the spread was positive.    The federal tax free advantage of the municipal bond interest, coupled with the perception of risk being relatively the same as the U.S Government allowed State and Local governments to obtain financing at rates lower than the U.S. Treasury until the end of 2007.

Something Changed in 2008

Since the beginning of 2008, and increasingly post the 2008 Lehman stock market crash and the multiplicity of Federal bail-out programs,  the Municipal bond market has been priced at a positive, rather than a negative spread to the U.S Treasury market.   This inversion of spreads took place well before the sweeping call by Meredith Whitney.   From the data in the following graph, the market re-pricing of the municipal bond market post the 2008 crash becomes apparent:


As you can see in the graph, the panic in the markets at the end of 2008 widened the Muni – Treasury spread to almost 3%, not atypical for virtually all markets relative to Treasuries at the end of 2008.  However, once the panic subsided later in 2009, the municipal market had difficulty returning to its historical negative pricing spread to the U.S. Treasury market.  In fact, as reflected in the table below, the average spread from 2009-2010 was a positive .32%.   One can merely speculate on why there was a market aversion to municipal bonds post crash, but the macro level data show several potential reasons.    The most obvious is the growing speculation that the tax free exemption of municipal bonds would be lowered or eliminated.   The other rational was performance of municipal bonds during the crisis.  The access to credit for municipalities in the crisis suffered – and the U.S government had to “come to the rescue” of many municipal governments with federally taxable Build America bond issues to shore up their financing during the crisis.  Although the Build America bond program was eventually curtailed, the market had established a new recognition that municipal bonds were much more subordinate in market risk profile to the Federal government, and this added degree of risk relative to Treasuries most likely contributed to the change in spread level.



But the data suggest there was a second wave of risk pricing that entered the market leading up to the point in time Meredith Whitney issued the general warning about the municipal bond market in December 2010.  Her warning focused on the under-funded pension obligations within many state and local governments across the country.    In general the timing of her call was poor.  The economy was in recovery and many state and local governments were cleaning up the mess that was left from the 2009 recession.    On a relative basis the market was already pricing in a higher degree of risk in the municipal bond market.  After the call was made, it opened up a buying opportunity that many astute investors took advantage of as municipal bond rates that spiked nearly to levels experienced in the 2008 crash.   From February 2011 until the beginning of 2013 the municipal bond market rallied almost 150 basis points.   At the same time, the average spread over Treasuries maintained a wide positive spread, reflecting the potential loss in tax advantage risk and the increasingly poor credit quality recognized among many issuers of municipal debt – particularly in certain municipalities in Illinois - Chicago, California – San Bernardino and Stockton, and Michigan – Detroit. 

As of the writing of this article, the spread in the municipal bond market relative to Treasuries has widened to .97%.   The spread has only been above this level 15 months since 1953, and the majority of those time periods were during the 2008 crisis.  Making the markets more unstable is the move upward in long term interest rates.  The double impact of issues that have the effect of depressing municipal bond prices have led to steep declines in price levels of many issues since the beginning of 2013.  

Default Risk Fear is behind the Widening of the Spread

The main driver behind higher risk pricing of municipal bonds relative to Treasury bonds presently is the issue being addressed in the Detroit bankruptcy proceeding concerning the status of municipal General Obligation bond holders.   General obligation bonds have historically have been viewed as “secured” and “virtually risk-free” if they have a covenant which in simple terms states that in the event that tax revenues are insufficient to cover bond payments, the municipality is required to take action such as raise taxes to remedy the situation.  It is this provision to enforce the taxation power that has generally led to the riskiness of the highest grade GO municipal bonds being viewed as very comparable to a U.S. Treasury investment from a preservation of capital standpoint.  

If the legal decisions handed down in the Detroit bankruptcy case perverts the interpretation of this provision in a way that would treat GO bondholders as “unsecured creditors”, then the riskiness of municipal bonds, particularly General Obligation bonds, must be re-assessed both on a case by case basis as well as in the aggregate.   Based on the current spread of interest rates on municipal bonds relative to Treasury bonds, the market re-pricing is well underway.   The current spread on the long-end of the curve is 200 basis point higher than historical average and a positive 100 basis points above the current 30 Year T-Bond.  For comparison purposes, consider that lower rated 20-30 year BAA1 corporate bonds are typically priced at 150 basis points over the 30 year Treasury, and the corporate bond market has zero tax advantage.    
Is 100 basis points a sufficient risk premium over Treasuries on the long-end of the market?  My assessment is that it most likely is, and possibly is overdone if the tax advantage of Municipal bonds is not removed.  All this said, it does not mean that in the short-run the fear in the market being driven by the Detroit case will not continue to cause the spread to widen even further.  

Don’t Confuse Rising Rates with Higher Default Risk

As the municipal bond market has been grappling with the default risk fear generated by the Detroit bankruptcy filing, there has also been a simultaneous upward move in longer duration bond interest rates.  The rise in the 10 year Treasury to 2.5% and the 30 year T-Bond to 3.5% from May through early July 2013 was an almost 100 basis point upward adjustment.  As a result, these longer term bond investments, including Municipal bonds, with 3%-5% coupons lost 10-20% in asset value during the time period.   This lose in value had nothing to do with the underlying quality of the investment.  It is a function of bond prices moving lower as rates adjust higher.

The rate move up in my opinion is not yet finished, but may be at an intermediate watershed.  I suspect that normalization of rates will occur when the 10 year Treasury is back to 3.5-4% and the 30 Year Treasury approaches 5%.  The primary issue in the move up on the long-end of the curve is whether the U.S. economy is strong enough to withstand the rate move.  At present, the prospects of a second rate move up remain elevated.    It would not surprise me to see continued Fed accommodation (no short-term rate rise) until long rates move to this level.

Problem with the Doomsday Perspective

Based on the market data, it appears we are moving to a municipal bond market which is likely to be priced at +1% Treasuries rather than its historic -1% on the long end of the yield curve.  The fear trade may actually push the spread even higher in the near-term.  The question is whether a “train wreck” of “black swan” event in this market is actually in the making.  That is the conjecture implied in the statements about “hundreds of billions in losses” in the municipal bond market based on 50-100 large municipality defaults.  When faced with this type of logic, I usually ask the question – “could this really happen in isolation while other traded assets in the public markets would trade as if nothing happened?”  My conclusion is that this scenario although certainly conceivable, assumes a complete collapse of contractual property rights in our legal system, and a cascading of city and state governments cashing in at the expense of private property owners – most of whom cannot vote in the district which is confiscating the property.  Such a scenario assumes chaos, and it would reverberate across all markets.  Sub-prime would not be contained.  

So, if you fear the municipal market because of what is happening in the current legal process, your only alternative will eventually be cash and gold because if the municipal market implodes, stocks, corporate bonds and many other investments will surely follow.  Presently I am personally not that pessimistic, but I do expect a negotiated outcome which will set a new precedent in the current bankruptcy proceedings – but the overall loses to bondholders over time will not be excessive in these worst case problem zones such as Detroit.    
  
Opportunities will Surface

Municipal bonds for taxable portfolios have historically been a very sound source of stable investment income, and I do not predict this will change regardless of how the court rules in the Detroit case.  The adjustment upward in interest rates and the added default risk premium now in the market from news about the Detroit bankruptcy is setting the stage for a buying opportunity.   In fact, I fully expect that there will be a mass rotation out of stocks within the next 6 months, much of which will find its way into the better returns now being offered into the municipal bond market.  The trigger will be investor realization of what is going to happens once the Federal Reserve actually becomes less accommodating later this year.   The critical issues to pay attention to if you are an investor in this market will be the impact on the spread as the Detroit court ruling proceeds and the stabilization of the long-term Treasury interest rates as the Fed tightens policy.    But even if Detroit is not clearly resolved, the risk premium for many municipal bond issues is approaching the over-sold stage.  The municipal bond market is both wide and deep.    There are many state and local governments that are substantially better credits than Detroit and Chicago.   My recommendation for investors at this stage is to get ready for the bargain hunting to begin, because the news feed is going to continue to depress the value of some very good investments as the resolution of the fate of the rotten seeds is determined.    

Daniel Moore is the author of the recently published book Theory of Financial Relativity - Investment Portfolio Guidance for a Fed Driven Bubble Prone Deflationary Era. All opinions shared in this article are expressly his own, and intended for information purposes only.


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