Playing Municipal Bonds

by: Carl Dincesen
Borrower-funded credit ratings play an inordinately powerful role in the municipal bond market to the detriment of investors. This out-sized influence has always existed because individuals, as opposed to institutions, own most municipal bonds.
Throw a dart at a listing of the 35,000 or so issuers of tax- and government enterprise-backed municipal bonds. The odds of picking one that has or will default is less than one percent. Unfortunately, using the same selection process, the odds of an investor landing on a bond that will maintain or improve its credit standing or relative trading value are not in favor of individual investors.
The price paid for a particular municipal bond is largely determined by credit ratings assigned by the “public” rating agencies. They're called "public" because their rating opinions are free to the public, paid for by borrowers using the ratings to market new bonds.
Credit ratings should be opinions on the risk of monetary default over a specified period of time. A top to bottom ranking (triple-A to C) is insufficient. Further, the rating report or credit analysis documentation should inform the reader about all of the facts and information so that he or she can reach the same or different conclusion, if so inclined.
The big three borrower funded rating agencies fail to deliver on both fronts when they rate state and local government bonds. Unlike municipal bonds, institutions are the primary holders of the relatively small universe of well-scrutinized publically traded corporate bond issuers who in many cases are subject equity analysis as well. Other than the agencies, no one is watching the municipal store’s credit quality. That is unless you have access to independent expert advice.
Compared to 30 years ago, the security backing state and local government bonds has been in steady decline while credit ratings have not. That same period saw the rise of municipal bond insurance. It was only a few years ago that fifty percent of new issues had insurance and triple-A credit ratings.
You could say the bond insurers masked the slide and relieved the historical problem of limited liquidity due to the array and sheer number of issuers. Unintentionally, they also abetted the slide by accepting less security for more premium.
Individual investors who own municipal bonds directly are at more of a disadvantage today because credit quality has declined while reliance on borrower funded municipal bond rating agencies has increased. As noted, the largest credit risk facing individual municipal bond investors is overpayment for the risk assumed, not actual monetary default. Will the bond's credit standing be stable, improve, or decline? If interest rates increase subsequent to purchase, a decline in credit standing would be particularly unwelcome. Credit spreads are narrow now, but could widen in absolute and relative terms.
As a bond investor, ask what is your tolerance for credit risk. That tolerance must be thought of in terms of probability of default. Over the next ten years, is the probability of default one in one thousand, or one in one hundred? When credit risk is defined this way, most investors are comfortable with one in one hundred over ten years. Some prefer better odds. Others would take more risk in exchange for more income. A table of default rating equivalents is available here.
If I were buying municipal bonds and knew little of credit risk other than the “ratings,” I would consider just two kinds.
  1. Voter approved unlimited tax general obligation bonds rated “single A” or better within the last year by two public rating agencies. My preference from high to low would be school districts (K -12 only), special districts (library, fire, and water), villages and towns, cities, and counties. I would look for a service area population of 10,000 to 50,000.
  2. Water revenue bonds secured by a first lien on gross or net revenues of the government’s retail water supply system, desert regions excluded. My rating and size screens apply except “customers” replaces “population.”
These particular bonds are impacted least by rating changes because the difference between high and low credit quality is usually obvious. They are less prone to rating inflation. Avoid double-A’s in the “vault” GO sector if you can because they typically have no place to go but down and are usually not worth the premium price from a credit perspective.
Venturing in to the other kinds of municipal bonds requires some homework or independent expert advice.
The ability to do your own analysis of municipal bonds has become easier in the last five years. Free access to the official statements used to market just about every municipal bond is available here.
In most cases, current financial statements are available as well. However, they will mean very little unless you know what is backing your particular bonds. That information can be found in the above referenced “official statement,” the equivalent of an offering circular for SEC regulated entities.
Disclosure: I am long MCO.

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