Municipal Bonds: Woe Is Me

| About: PIMCO Intermediate (MUNI)

Thank goodness, the hype about defaults has quieted down, just in time for an event that could do far more damage because it will be misunderstood. I am referring to a 25% probability the State of California will not have the cash this May and June to redeem billions in revenue anticipation notes sold to the public this past December.

Should that occur, a municipal bond buying opportunity on a scale not seen in decades would unfold.

Only near historic low interest rates could dampen the party for new investments. That is if state and local government issuers tap the market and many will based largely on construction contract commitments. The rest have degrees of optionality based in part on borrowing cost.

Very little must be issued to redeem maturing debt, California being a good part of that small amount. Some pros are publicly cautioning about a return to volatility in the near term and California notes are probably the reason why.

This would be unfortunate because the risk of monetary default on the California general obligation bonds is minimal for the foreseeable future. The worst damage would be to investors who not that long ago paid high-grade prices for the state’s bonds based on AA ratings given by the public rating agencies. The word “public” is used because those ratings are free to the public when an issuer sells bonds. They are printed on the cover page of the offering statement and used to advertise the bond issue.

California has not had a balanced budget for ten years. Common sense alone would tell an investor that the State’s bonds were over rated and overvalued pre-recession. Big rating changes come as either a big surprise or when everybody knows and is expecting one.

There are too few municipal bonds outstanding but many of those issued do not compare favorably to the norm thirty years ago when voter approved general obligation bonds predominated. Still, public infrastructure is not being maintained let alone improved. Total municipal bond principal outstanding, about $2.8 trillion, is little more than the $2.5 trillion spent annually just on healthcare in the U.S.

Today an investor is more likely to get certificates of participation than property tax secured general obligation bonds. Certificates grant to the holder the right to receive a share of an appropriation by the governing body to pay rent that mirrors debt service on appropriation backed "debt". The appropriation is a device for government to comply with laws prohibiting the incurrence of debt without voter’s approval. An appropriation is just that, an optional expenditure for each succeeding governing body to decide to make or not make.

Don’t expect any relief from the court if the appropriation is not made unless your bond has a use and occupancy clause, prohibiting the government issuer from occupying the facility if rent (debt service) is not paid. In any event, do not expect to see a school or administration building shut and sold for who knows what amount, the real point is that holders of certain certificate backed obligations at least have an enforceable contract and will be paid if not on time, eventually as long as the facility remains essential.

All else equal, the public rating agencies don’t appear to think the absence or presence of a “use and occupancy clause” is worth a difference in their credit ratings. This is but two less than optimal “security” variations in a long list offered to investors today. Public credit ratings barely distinguish these issues from the real thing, bonds secured by a lien on tax revenue.

There is nothing inherently wrong with the newer financing structures that have evolved. Is credit risk adequately delineated by the public rating agencies? We think not, but the real question is; are municipal bond investors being fairly compensated for the credit risk assumed. The answer is yes and no, depending on the accuracy of the credit rating awarded the particular issue, which could be influenced by the size, and borrowing frequency of the issuer.

Ratings used by issuers to sell municipal bonds play a much bigger role in setting credit spreads than in the corporate market. Yield is not nearly as true an indicator of risk as it is for corporate bonds. Unlike investors in the corporate bond market, municipal investors had no place to go for a second opinion, until now. A new company, Benchmark Bond Ratings, provides private rating reports for the exclusive use of its clients.

Should California squeeze by and refinance the notes, and the odds are it will, the coast looks clear of any event approaching the size of a state note default. The problem in California is now more political than credit.

The bigger issue is how will municipal bond investors fare going forward. It is not much about defaults; it is about the impact public ratings have on market value in the short and long term. Benchmark Bond Ratings is about helping investors avoid poor performers and identifying issues where returns are and will remain consistent with risk assumed. There are very few bad municipal bonds but many where long-term performance will suffer as a result inaccurate ratings.

More information on the revenue notes can be found here.

Disclosure: I am long MCO.