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Municipal Bonds: Unfortunate Unintended Consequences Or Whitney's Revenge 4 comments
In the fall of 2011 banking analyst Meredith Whitney caused quite a stir in the normally placid world of the US municipal bond market. These bonds or Munis as they are known are usually issued by local governments in the US. They can be issued by all sorts of lower political subdivisions including states, counties, and municipalities. They are also used for raising money for other infrastructure projects like sewers and roads. Some states also allow nonprofit organizations like universities and hospitals to issue these bonds. The bonds are considered unusually safe. So when Ms. Whitney predicted hundreds of billions of dollars of defaults in 2012, $19.1 billion funds flowed out of the $3.7 trillion market.
But then nothing happened. Instead of a massive meltdown, there were only $2.8 billion worth of defaults in 2011 and only another billion of defaults were added in 2012. Presently out of tens of thousands of projects only 204 deals are in default or about 0.55% of the total. So Ms. Whitney's prediction was way, way off. Or was it?
For several years now the Federal Reserve has suppressed interest rates. The result is that investors especially institutional investors including pension fund managers have been searching the globe for any investment that pays a decent yield. The out flow of funds prompted by Ms. Whitney's prediction reversed with a vengeance. Over $50 billion flowed into mutual funds and ETFs specializing in Munis. The demand for the bonds was so high that yields for 20 year general obligation bonds were forced to a low of 3.29%, a yield not seen since 1967. The riskiest of these bonds were the most favored. These high yield bond funds account for only 11% of the funds but attracted 20% of the money.
It may be that Ms. Whitney's prediction may have been exaggerated and a little premature. In December the rating agency Fitch also warned about the safety of these bonds. Fitch expects to downgrade dozens or even hundreds of municipalities in 2013.
What is most interesting about the Muni market is that its problems are very similar to problems of bonds in other countries especially those in emerging markets. They are lightly regulated. They are subject to political influence and they lack transparency.
While most stocks and corporate bonds are subject to stringent listing and reporting requirements from the US investment watchdog, the Securities and Exchange Commission (SEC), the Muni market is exempt. Unlike stocks, Munis are not required to provide audited financial statements. Disclosures like a potential bankruptcy or a criminal investigation are immediately required for other investments, but are often delayed by issuers of Munis. Until recently rating agencies did not consider unfunded pension liabilities. A recent SEC report described the Muni market as illiquid and opaque.
While the low interest rates have allowed many financially stressed municipalities to save money for new projects, they have created their own stresses in other ways. Like their European counter parts, many municipalities made generous retirement promises to civil servants, especially to their politically powerful and connected unions. What they never provided for were the actual funds to pay for the plans.
Two examples stand out. Puerto Rico is part of the US but has a special status as a commonwealth and has never asked for or received statehood status. It has problems that are similar to Greece: poor tax compliance, a shrinking population, political stalemate and a stagnant economy. Its main pension fund serving about 250,000 past and present government workers is only 6 percent funded and could run out of money as soon as next year. A fund for 80,000 teachers is only 20% funded. Nevertheless its bonds are widely held. They pay interest that is 2.5% higher than other issuers, because they are rated just one or two levels above junk. According to Standard & Poors there was a one in three chance of a downgrade in 2013. A downgrade could provoke wide spread selling by institutions required to hold only investment grade bonds.
Puerto Rico's case may be severe but it is hardly unique. The state of Illinois has an unfunded pension liability of $96 billion with problems that date back as long as 70 years. Rather than raise taxes it was simply easier to not fund the pension liabilities. Other states with similar problems include included Connecticut, Hawaii, Illinois, Kentucky, Massachusetts, Mississippi, New Jersey and Rhode Island.
The irony of the pension mess and its effect on Munis is that it has been made worse by the actions of the Federal Reserve. By lowering interest rates it has made it all but impossible for pension fund managers to get decent returns. The Fed has always maintained that a recession would be worse. By manipulating the market they may well cause what they sought to avoid.
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This post has 4 comments:
The other issue is like another country I study, China. There are insufficient laws requiring accurate, complete and timely information. So the size and extent of the problem is difficult to determine especially for retail investors.
She points out "a lot of the problems that the uninitiated encounter in trying to understand credit risk in the municipal bond market relate to the facile distinction between general obligation and revenue pledges rather than an emphasis on the differences between the actual borrowers in the “municipal” bond market – by which we really mean the “tax-exempt” bond market. Governments issue both general obligation and revenue debt and they create a lot of special districts and independent issuers that complicate analysis. But there is also revenue debt that is issued on behalf of non-governmental entities that is not even remotely similar in nature. The federal tax code allows states to issue a limited number of tax-exempt bonds for private business use every year. These bonds are issued on behalf of private (corporate) borrowers and are repaid from private resources. There are also a host of bonds issued on a tax-exempt basis on behalf of non-profit entities, like hospitals and colleges (although you would probably be surprised by the types of enterprises that count as charitable organizations under the federal tax code these days). This is not government debt. It is often not even a question of whether they serve an inessential or essential purpose vis-à-vis a governmental entity – they are simply getting a government subsidy for economic development or other purposes. Literally the only thing these bonds have in common with government debt is their tax status, and yet they are lumped in with “municipal” bonds for statistical purposes. This is where the vast majority of defaults occur, and it is why aggregate default statistics are mainly only useful for making fun of Meredith Whitney. Most of the “idiosyncratic events” that cause defaults among specific sectors do, in fact, have well-documented narratives (e.g., dirt bonds)."
Be sure to read her material before venturing out trying to explain a very complicated subject such as municipal debt.
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