[This article was originally published by Summitas at www.Summitas.com]
“Reports of my death have been greatly exaggerated.”
That was Mark Twain speaking, of course, but it might just as easily have been the municipal bond markets. For the past several months, prophecies of doom have terrified muni investors, resulting (according to Lipper) in net withdrawals from municipal bond mutual funds for 18 consecutive weeks.
Is the fear and trembling justified? Yes and no. Private investors rely heavily on munis to form the core of their fixed income portfolios, and this is typically their “sleep well” money. If muni issuers are in serious distress and defaults are about to skyrocket (as Meredith Whitney and Nouriel Roubini have predicted), this is obviously an area of concern.
There is no doubt that many states and cities are under financial stress, but defaults are unlikely to be widespread and are highly likely to be concentrated in sectors other than general obligation and essential service bonds. In fact, the panic exhibited by retail investors in munis may present opportunities for calmer investors. (Think closed-end muni bond funds.)
Why do I think widespread defaults are unlikely? Simply because state debt isn’t that high. Stressed sovereign nations have debt levels ranging from 165% of GDP (Greece) to 1,224% of GDP (Ireland). But the median debt for a U.S. state is only 7.3% of Gross State Product.
What has certainly changed, and probably for good, is that the muni bond market has evolved (as PIMCO puts it) from a “yield” sector to a “credit” sector. In the Good Old Days, when muni defaults were unthinkable and issues were often backed by monoline insurers to boot, investors could focus solely on yield. If you were willing to bear duration risk, you could reach for yield. If you weren’t, you stayed short and accepted lower yields.
Today, and for the foreseeable future, investors in munis will also have to take credit risk into account. Those who are willing to bear credit risk can reach for return by buying revenue bonds, lower-rated bonds issued by stressed issuers, or smaller, less liquid issues. More cautious investors will want to keep their sleep-well money in general obligation and essential service bonds.
The world has changed because the under-disclosed, over-leveraged balance sheets of state and local issuers (especially adding in unfunded pension obligations) finally caught up with them. The SEC has even taken action against several municipal issuers whose disclosure has been especially poor. And this issue isn’t likely to go away any time soon: However diligent governors and mayors may be at trying to balance their current budgets, bloated balance sheets are a much tougher nut to crack.
Moving into a “credit” world is a bit of a Roach Motel. Once investors start worrying about credit, they start demanding more financial information from issuers. The more information that is disclosed, the worse the picture looks. Issuers whose credit once seemed sterling will now have to pay up to raise funds, while issuers who once seemed marginally okay may find themselves frozen out of the bond markets until they clean up their acts. For all municipal issuers, the credit world is here to stay.
But the credit world also has its advantages for issuers. I mentioned above that in the past muni defaults were “unthinkable.” The notion was that if a muni issuer defaulted, it would be forever banned from the credit markets. But once investors get used to the idea that creditworthiness matters, even heretofore profligate issuers will find that they are not forever consigned to the seventh circle of Hell.
The reason isn’t that bond investors have short memories, but that bond investors by necessity evaluate issuers on a looking-forward basis, not a looking-backward basis. Once an issuer has taken steps to clean up its balance sheet, it is likely to be welcomed back into the fold. In the sovereign markets, for example, sovereign defaults have been relatively frequent, but sovereign issuers who default often successfully return to the bond markets after only a few years (Argentina, for example).
In sum, defaults aren’t likely to be widespread in the muni markets, but sleep-well money should stay with general obligation bonds and essential service bonds.
Please note that this article is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
