In the fourth quarter of 2008, the municipal bond market collapsed along with the rest of the credit markets. Lately there has been a small revival. Still, depressed bond prices and wide spread credit concerns leave open big opportunities for investors in the new issue and secondary market, if you know where to look.
Long maturity tax exempts on average now yield 130% of comparable Treasury bonds and that’s before the exemption benefit. A portion of that differential may be attributed to what many have termed artificially low Treasury rates. Not that long ago, exempt yields averaged 75% of Treasuries. At no time since the 1930’s, has a full understanding of municipal credit risk been more valuable.
While some credit delineation is occurring, much more so in the corporate bond market, all municipal bonds still remain tarred with the same brush. Will there be widespread defaults? No, but unless there is a fast reversal of current economic trends, payment default rates will likely increase dramatically from their very low historical rate. However, defaults will not be spread evenly across the more than 40 different kinds of credit risks that comprise the municipal portion of the tax exempt bond market
Today, an investor should not buy or sell without a full understanding of the bond’s credit risk. Selling a perfectly sound bond makes no sense in today’s market. But replacing a high risk category holding with a low risk bond does deserve consideration.
Over the last 20 years, the municipal market has been willing to accept weaker forms of pledge revenue and bond covenants, greater complexity, unfunded contract liabilities, and circumnavigation of debt limits.
At the same time, what a municipality can and cannot finance, and what can and cannot be pledged, is still largely controlled by state statute and state constitutional provisions. These controls almost always work to the benefit of bondholders because states have a self interest in setting parameters that reduce the likelihood of sub division debt repayment problems.
Legal underpinnings are precisely why in the mid 1970’s NYC defaulted on its general obligation notes but not on its GO bonds. Principal repayment of the notes was not funded and was expected to be redeemed from the sale of additional notes. When the degree of the City’s financial problems became clear, the market refused to buy any additional NYC notes or bonds.
This led to the creation of the Municipal Assistance Corporation (MAC Bonds) and “moral obligation” financing, the first major circumnavigation of a state’s constitutional debt limit. “Moral obligation” based financing is now prevalent in many states. These financings do not have a pledge or lien on any tax. Instead, repayment is subject to an annual appropriation from either state general funds or, in the case of NY Mac bonds, a portion of the State sales tax levied in NYC.
Unlike corporate debt, the starting point for municipal credit evaluation, beyond the fact that most sub divisions are not subject to competition, is that these entities do not typically seek to generate revenue beyond current expenses. Because of this, many issuers can, when necessary, increase rates and charges and cut back on service without serious detrimental effect to their government franchises. Corporations, however, with few exceptions, can not simultaneously shrink in size and raise prices.
To a greater or lesser degree there is a built in margin of protection that does not typically exist with corporate debt. In default, recovery values on corporate debt are low and typically always less than 100% on securitizations. Recovery is 100% on most municipal bond defaults to date. Needless to say that avoiding payment default in the first place is the number one priority for bond investors.
Credit protection margin is based on the application of a reasonable worst case scenario to gauge the ability to withstand the scenario which may or may not materialize during the life of the bond. For those who think in terms “what if”, there is a natural tendency to redefine reasonable as times get worse. Nonetheless, it provides investors with a perspective that is not prevalent in the formulation of Rating Agency credit ratings. Credit ratings on tax exempt debt are necessary but are heavily influenced by the current status in the here and now in the context of the prevailing local, state and national economic environment as well as positive and negative developments unique to the issuer. Ratings change and investors are free to buy and sell.
The protection margin assessment deserves more attention in the selection process because most municipal bonds are held to maturity. When the economy is poor, without an assessment of the margin, investors gravitate to the always scarce supply of un-enhanced double and triple “A” bonds. In fact, the margin can be equal or superior on lower rated bonds. Protection margin opinions do not correlate very well to credit rating opinions.
Capital Charges – Underpinning for Credit Protection Margin Evaluation
An excellent way to get a handle on delineating municipal credit risk is to start by looking at the municipal capital charges assessed by the rating agencies to the bond insurers who assume long term risk that can not be sold.
Municipal capital charges represent an informed estimation about the likelihood of monetary default in a 1930’s depression severity. Capital charges for investment grade municipal debt stated as a percent of average annual debt service range from 2%to 52% from S&P. Fitch employs the same approach and their charges are very similar to S&P. Moody’s method is not so transparent but their pecking order of municipal risk categories is similar.
S&P’s capital charge table for tax exempt bonds is available online. The capital charge is a gradation of average credit risk. Ratings change but the capital charge category does not. For instance, the capital charge for an A rated general obligation public school district bond is 3%, while an A rated tax exempt not for profit stand alone hospital bond has a capital charge of 25%.
It is not clear why the rating agencies did not formulate capital charges for mortgage securitizations on a worst case depression scenario or why the rapid decline in mortgage underwriting standards was not addressed in a timely manner. Had this not been the case, many securitizations would have been uneconomic and never gotten off the ground.
Whether the capital charge percentages are correct, too low or high is essentially relevant only within the bond insurance business. It’s the pecking order (low charge low risk, higher charge more risk) that is important for investors. For example, why does the general obligation school district category carry one of the lowest capital charges even among the various general obligation categories? Basically, unlike cities, towns and counties, school districts can, in extremis, temporarily cease operation to balance the budget. Full taxes remain due and the component of property taxes levied to pay debt service (bond principal and interest) can only be used for debt service payment and for no other purpose under several state constitutions. To boot, the tax levy for debt service is typically a small percentage of the total tax levy. Default would not provide significant operating relief for most school districts or general purpose municipal entities.
After review financial statements the evaluation should begin from a “what is not readily apparent” point of view. In other words, how much inherent protection margin is available beyond what is apparent in current financial statements?
It is necessary to understand how the entities purpose, financial obligations, financial resources, bond pledged revenue and the relevant constitutional and statutory provisions support or detract from each other. At that point, it is not difficult to gauge the ability to pay under stress scenarios.
1) All things being equal, bond issues that rely on contracts (lease and other forms) with the third party or parties to pay debt service are generally riskier than bonds secured with a direct pledged security interest with no reliance on third parties.
A classic example is the complete default with no recovery in the mid 1980’s on $2.3 billion of bonds issued by the Washington Public Power Supply System. The bonds were secured under take or pay power supply agreements with a multitude of local municipal utilities located in Washington and Oregon. The bonds were issued over a few years starting in the late 1970’s to build three nuclear power stations and were rated A1/A+. It became apparent that it would take and additional $1-$2 billion to complete the projects. At the same time, nuclear power was falling out of favor and the national economy was sinking. A group of the participating local utilities sued the Power Supply System claiming the contracts they had entered into were not enforceable. The Washington State Supreme Court, a publicly elected body, agreed, letting the local utilities completely off the hook. Political risk often increases with complexity.
2) Pledged property and other taxes can be limited by law as to rate and/or amount. Some but not all general obligations bonds in Ohio and several southern states are secured by property (ad valorem) taxes that are limited as to rate. This can pose especially difficult problems if the entity experiences substantial reduction of property values. By the same token, local sales tax secured revenue bounds could be at risk if the sub division has a concentration of big tick retailers such as car dealerships. In the event of a shortfall, the subdivision typically has no obligation or authority to increase the sales tax rate.
3) There are several billion dollars of tax allocation/tax increment bonds outstanding and issued by local agencies and districts in California. Bonds are issued to fund local infrastructure. They are secured by the property tax levied on the incremental assessed valuation in the district over and above the base assessed value that existed prior to the creation of the district. In cases where the base (pre redevelopment values) represents a significant or large percentage of the redevelopment district’s total assessed value, for example 50%, leverage comes into play. Consequently, if the district’s total assessed value declines by 20% this districts’ incremental value and tax revenue supporting the bonds will decline by 40% because valuation declines are taken off the increment, not the base and increment. By constitutional law, the tax rate in the district cannot be greater than the uniform tax rate levied by the sub division within which the district is located.
4) Toll road revenue bonds credit risk varies widely. Some have a deep protection margin while the margin on others is thin. The same is true for bridge, tunnel and airport revenue bonds. The margins on certain toll and airport facilities are so deep that the private sector has paid very large up front sums for the right to operate the facility under a long term lease.
5) Airports revenue financings have unique credit risk characteristics. What is the mix of traffic? How much traffic is driven by local demand versus demand as a destination? What is the quality of connecting traffic, natural or artificial based on airline strategies. In the context of these characteristics, the level of existing and proposed expansion debt can carry much more weight than in typical municipal enterprise financings.
6) Bonds secured by large public colleges and universities, as an example, can be close to bullet proof when the security provided is a first lien on gross collections of tuition and/or mandatory student fees. Every in-state student represents a cost to the state. When stressed, states typically increase tuition and/or admission standards to reduce the aggregate amount of the state subsidy. However, the percent of tuition revenue necessary to service the debt is typically less than 10%, providing very large debt service coverage margins even with very large enrollment declines.
7) Tax exempt bonds secured by not for profit entities comprise a significant portion of the tax exempt bond market. They are not secured by governmental taxes, fees or revenue from governmental enterprises such as local municipal utilities. These tax exempt non municipal bonds are secured by a wide assortment of mostly not for profit entities such as hospitals, museums, nursing homes and private colleges and universities. They carry higher capital charges compared to municipal bonds. Like for profit corporations they are subject to greater degrees of competition. Protection margins on average are thin. Bankruptcy provisions are the same as those applicable to for profit corporations
Each of the 60 different kinds of tax exempt credit have overlapping and unique credit characteristics too numerous to cover here. Given the current state and direction of the economy, individual and intuitional investors can at least start by employing capital charge categories to determine which bonds should be at the top of your “to evaluate for purchase or sale list”.
A continuation of the article covering the following and other topics is available on benchmarkbondratings.com.
- Municipal financing that circumnavigates statutory and constitutional debt limits.
- Public employee pension and other retirement benefits
- Derivatives in municipal finance
- Bond insurance
- Municipal bankruptcy