This is not your father’s municipal bond market. Since the financial market disruptions of 2007, the municipal bond market has transformed from a rates-driven market to a credit market that trades much more closely with the corporate bond market than Treasuries.
Credit risk has become a primary driver of valuations, and an in-depth understanding of the finances and other credit variables of issuing entities has become a prerequisite to successful investing in the market. Moreover, with most of the municipal bond market no longer rated triple-A, capital requirements to hold bonds have risen substantially, reducing dealers’ willingness to hold inventory. The municipal bond market has thus become less liquid, and trading in it now requires the skills of a credit trading desk, with the knowledge and ability to source and sell blocks of bonds in the most efficient way possible.
Prior to January 2007, the municipal bond market had an aura of safety and predictability. Insurers such as MBIA, Ambac and Assured Guaranty provided an insurance backstop to the underlying credit risk for a large portion of the market. With the insurance wrap, 70% of the Bloomberg Barclays Municipal Bond Index was rated triple-A and bonds were priced largely at a premium to Treasuries. The municipal-to-Treasury ratio reflected the benefit gained from the tax-exempt status of municipal bonds relative to Treasuries. In this environment, liquidity was higher as the triple-A rating of most bonds belied their underlying credit risk. But by the second quarter of 2007, the financial crisis had enveloped the municipal bond market and shaken it to its foundation, profoundly altering the dynamic and makeup of the market.
The municipal bond insurance industry started in 1971. By 1980, only 3% of the market was insured — but in the 1980s, the bond insurance market grew rapidly. By 2007, approximately 60% of the municipal market was insured, with the vast majority rated triple-A. About 85% of all triple-A-rated debt achieved the rating not on the credit quality of the issuer but as a result of the insurance wrap.
Municipal bond insurers began expanding into higher margin markets, extending insurance coverage to mortgage-related products and collateralized debt obligations. However, in the second quarter of 2007, as the mortgage market began to unravel, investors started to become concerned about the outstanding obligations of the insurers and questioned whether their balance sheets were strong enough to permit them to honor those obligations. As their liabilities ballooned and the scope of potential losses increased, their credit ratings were called into question. In late 2007 and early 2008, all the major insurance guarantors were downgraded, in turn leading to the downgrade of the insurance wraps.
With each downgrade, the universe of triple–A-rated securities shrank rapidly. By December 2009, the triple-A-rated portion of the market had dropped from a whopping 70% to just 12%. In a market formerly dominated by triple-A-rated issuers perceived as free of risk, the credit risk of the issuer suddenly became paramount.
Bloomberg Barclays Municipal Index Market Structure, July 2005–July 2013
Credit risk starts to matter in the municipal market
The difference in corporate and municipal bond spreads to Treasuries has two components: the credit risk of corporates relative to municipals, and the tax advantage of municipal securities. From July 2005 through January 2008, municipal securities traded at a premium to Treasuries and similarly rated corporates. Single-A-rated corporate bonds traded at an average spread to Treasuries of 97 basis points, while A-rated municipal bonds traded at an average spread of –44 basis points.
In mid-2007, amid the global financial crisis, spreads for both corporate and municipal bonds relative to Treasuries began to widen. Municipal bond prices were affected by both wider credit spreads and the loss of triple-A credit ratings by insurers. As the rating structure of the market changed due to the downgrade of the insurers, through 2008 and 2009, the difference in spreads for A-rated corporates and A-rated municipals narrowed as investors began adapting to the changes in the market. Starting in 2010, the market no longer saw any meaningful difference between A-rated corporate bonds and A-rated municipals.
The market started pricing in a credit risk component to the municipal market. As corporate issuers began to bolster balance sheets and several municipalities teetered on the brink of bankruptcy, investors started to assign a greater risk premium in aggregate to municipals compared to corporates. Since 2010, the average spread to Treasuries for A-rated municipals has at times been wider than that of A-rated corporates, to the point that the market is even ignoring the tax advantage of municipals over corporates.
This development resulted in municipal bonds becoming an attractive base of assets for nontaxable investors who had the wherewithal for deep credit analysis and, in many cases, found the valuations to be appealing. Over the last two years, a large number of taxable investors have invested in municipal bonds.
Spreads to Treasuries of A-Rated Municipal and Corporate Bonds, July 2005–December 2012
Implications to changes in the market and managing a municipal bond portfolio
The changes in the rating structure of the market had an impact on the liquidity of the market. Since January of 2010, with only 12% of the market rated triple-A, the municipal inventories held on the balance sheet of broker-dealers represented a potential risk in a market environment that had firms fighting for survival. The large broker-dealer firms dramatically reduced their municipal bond inventories. Though they are still willing to facilitate trades by crossing transactions, they are less willing to take the securities into inventory to help facilitate a trade. The change in municipal bond market liquidity has contributed to an increase in the spread as the liquidity premium has increased. In this environment, having an experienced trading staff with a detailed understanding of the market is crucial.
General obligation and revenue bonds
Developments in recent years have also had an impact on how the market views revenue bonds and local government bonds. Broadly speaking, general obligation bonds are backed by the credit and taxing power of the issuing jurisdiction, while revenue bonds are backed by a specific revenue stream of the issuer that is used to service the debt obligation.
General obligation bonds, which had generally been viewed as safe in the years leading up to the crisis, were repriced as riskier assets as local authorities struggle with budget deficits and growing pension obligations and labor costs. The lack of political appetite for increasing taxes or reducing services has led several local authorities to consider bankruptcy as an option to alleviate some of the budget concerns. Thus, to invest in general obligation bonds, investors must understand current budget constraints and the ability and willingness of politicians to increase taxes. Investors must also understand the structure of the security and how it would be treated in the case of a bankruptcy. Not all general obligation bonds carry the same risk profile.
Meanwhile, most revenue bonds are no longer cushioned by an insurance wrap. As a result, they now trade based on the underlying credit quality of the issuer. The research process of analyzing revenue bonds has come to be similar to that of corporate bonds. The investor must understand the structure of the issue, whether the revenue stream is stable and sufficient to meet the interest and principal obligations, the probability of a bankruptcy event, and the recovery value of the underlying asset. In essence, the fundamental analysis of a municipal bond now must include all the elements of an analysis of a corporate bond.
Size of the municipal bond market
Complicating the research process further is the breadth and diversity of issues as well as structures that range from local and state general obligations to revenue bonds. Consider this: as of July 31, 2013, the Bloomberg Barclays Municipal Bond Index had 46,962 issues compared to the Bloomberg Barclays U.S. Aggregate Index’s 8,395 issues. To conduct municipal bond research and gain an understanding of a market that has almost six times the number of issues as the taxable market requires a significant long-term commitment of resources in both research and trading.
The financial crisis irrevocably altered the municipal bond market from a rates-driven market to a credit market. The focus on credit risk has changed how the market trades and the ways in which investors view its credit risk. As a result, successful investing in municipal bonds requires knowledge and experience in credit research and portfolio construction and management as well as deep trading resources.
- The financial crisis irrevocably altered the municipal bond market from a rates-driven market to a credit market
- As most municipal bonds no longer have an insurance wrap, the ratings have declined in aggregate
- The change in the rating structure has had an impact on market liquidity and how municipal bond risk is viewed
- The difference in municipal and corporate spreads has all but disappeared