August 2014 Monthly Credit Review – “The Municipal Bond Market: It’s History and Personality”

Overview:

The month of August saw more “safe haven” investing, due to European issues. Municipals have kept good pace with US Treasuries, and investors seem comfortable with the asset class as a safe haven. As the summer comes to end, the municipal market will be moving into a seasonally weak time of year. Any cracks in the US Treasury market could create bigger ones in “muni-land”.

Recently, we had a Financial Advisor ask us about a municipal “primer” for a customer. After thinking about this, I thought it would be great to review the history and personality of the municipal market. To know it, gives you even more reasons to Love It!

Municipal Market Review:

The economic concerns of Europe continue to suppress yields in the US, even though signs of economic strength and employment growth become more prevalent. This macro environment, combined with issuers’ apprehensiveness to sell more bonds, created another strong month of returns for munis. More specifically:

Municipal bonds slightly out performed US Treasuries. Municipal yields performed as follows:

  • 10-year muni yields decreased 19 bps over the month, down a total of 87 bps since August 2013.
  • 25-year muni yields decreased 27 bps over the month, down a total of 140 bps since August 2013.
  • Municipal issuance continues to trail levels in 2013 by 13%.
  • Curve relative value still shows municipals to be rich 10 years, ok value 15 to 20 years, neutral in 25 years.

Updates on Muni News Items:

  • US Bank Liquidity Rule, that was set to exclude municipals from the list of “liquid assets” for banks, is now under review. It appears the Federal Reserve may allow certain types of munis to be included as a “liquid” asset, which will help the municipal market. Banks are not big investors in muni bonds (roughly 10%), but by excluding them it would slightly raise the borrowing costs for issuers.
  • The State of Texas set an all-time low yield on its issuance of 12-month tax and revenue anticipation notes. The market bought $5.4 billion at a .134% yield for notes due 8/31/15. This means if you invest $1 million in Texas TRANs, you will receive $1,340 in interest over the next 12 months.   Does it seem worth effort?
  • Puerto Rico: There continues to be a lot of behind the scenes activity going on. Banks, hedge funds and the posse of Puerto Rico issuers appear to be finding ways to make things work out, but prices are all over the place, depending on the PR issuer. Uninsured general obligation bonds are trading at roughly 75 to 80 cents on the dollar, sales tax bonds are trading from 80 to 85 cents, while the electric utility’s bonds (PREPA) are trading at 50 to 55 cents on the dollar. What has been impressive is the lack of carry through to the rest of the muni market. I guess you can say Puerto Rico is now on its own municipal market island.

Investment Strategy Review

As the municipal market continues to grind higher, we are concerned that, when interest rates are no longer suppressed due to the fears in Europe, the resulting sell-off will be faster and harder. The next 60 to 90 days usually represent weak technicals in the municipal market. If the US Treasury market starts to sell off, the muni market could fall further. We continue to be patient and remain defensive with any new investments. This does not mean buying 12-month Texas Transportation bonds. More appropriate would be to deploy a short-call cushion strategy. For more details please feel free to give us a call.

The Municipal Bond Market: It’s History and Personality

The first officially recorded municipal bond was general obligation debt issued by the city of New York in 1812 to build the Erie Canal1. Soon thereafter, many US cities issued bonds to fund public education and various infrastructure needs. By the late 1800s, a great deal of local debt was issued to help build the railroads. This was to become quite controversial seeing how the railroads were owned by private enterprises, not municipalities. The “Panic of 1873”, and the several years of depression thereafter, caused roughly 24% of the outstanding municipal debt to default. Yet, from this chaos came widespread reforms and reassessment of how municipal debt should be issued and for what purposes. This brought about the following changes:

  • The need to restrict the use of municipal bonds for the “public” good, and a legal opinion from counsel to validate its use.
  • Credit ratings were introduced in 1890 and 1909.
  • Newspapers began reporting activities of the municipal market in 1891.
  • Full federal exemption from taxes was defined in 1913.

The municipal market continued to grow, slowing down during the Great Depression of the 1930s. This was a tough time for the municipal market as a sudden rise in relief expenditures, coupled with a drastic drop in tax collections led to widespread municipal bond defaults. From 1929 to 1937, there were over 4,700 municipal defaults, roughly 7% of the average outstanding debt. Chaos followed, and numerous types of legislation were introduced to address state sovereignty and federal government concerns. As a result, Chapter 9 was born in 1946, and ultimately most municipal defaults were worked out in less than 18 months with payments being made in full. The final amount of debt defaulting was 0.5% of the average outstanding debt. Arkansas was the only state to default in 1933, but in the end, they made investors whole.

By World War II, the usage of municipal bonds had expanded greatly for a variety of different functions. At that time, the local debt per capita was $145. By 1998, it was at $1,791, showing the acceptance of the municipal bond market by the investment community and the general public.

Today’s Municipal Bond Market:

I take great pride in telling people what I do for a living. I help municipalities finance the building of schools, hospitals, highways and other projects for the public good. This is not to say that there hasn’t been some fraud, deceit and misjudgments from the entities who issue bonds along the way. When most people think about the municipal market, they think of the state of California, the City of New York, and other big name cities and states. Yet even smaller municipalities use the municipal market as an efficient vehicle for its citizens to fund local community projects that provide essential services. It is regionally focused, trade volumes are small and the investors are its ultimate service user (the individual).

(1)The Fundamentals of Municipal Bonds, by Judy Wesalo Temel, Bond Market Association

Let’s first look at the relative size of the municipal market. The easiest way to do this is to compare it to other US capital markets. As you can see from the chart, the municipal market is the runt of the group when comparing in dollars. Yet the number of issuers is relatively large creating a small, fragmented market that requires a lot of navigating. The demographics of the municipal market help explain a lot of the market’s uniqueness and inefficiencies. It also explains why it has always remained among the most under-appreciated asset classes of the financial planning world.VolumeAnother small town feature of the municipal bond market is that individuals are typically the ones who own them. The chart below shows the holders of municipal bonds as of September 30, 2012.

Let’s take this information one step further. If we add up the direct (Households) and indirect (Various Funds and Money Market Funds) ownership, you will see that 73.4% of all municipal bonds are held by individuals. This illustrates that the citizens are providing the financing for their own community projects.

On average, credit quality for municipal bonds is very strong, especially when compared to US corporate bonds. Below is a chart showing the break out for municipal and corporate bond credit ratings:

Rating

Over 60% of municipal credits are AA-rated or higher, compared to only 6% of corporate bond credits. There is a higher amount of NR (non-rated) for municipal bonds. This is mainly related to the small amount of debt outstanding for some issuers and the uneconomical costs to have it rated by a credit rating agency. The category NR is not necessarily an issuer being of lower credit quality, but could be an issuer trying to save money.

Geographically, municipal issuance can vary from year to year. Some critiques of the municipal market claim that one of the problems with the current financing system is that it benefits the big states who issue a majority of the debt. In my opinion, this seems appropriate, because these states are also home to the majority of the population.

The chart below compares percent of issuance for 2010 to 2012. It shows that the top ten most populous states, which hold 51.8% of the population, account for 51.6% of the municipal debt outstanding. This data shows that municipal financing is benefiting the population in a proportional fashion. The states that need to support the most residents use the market the most.

Picture4

Finally, let’s review what the proceeds of the bond sales are being used for. Chart 8). Below is a chart from MSRB showing the use of municipal bonds and the various types of projects they have financed.

ProceedsGeneral Purpose (28.5%) is the largest category usually referring to General Obligation bonds, which means the municipality has made a decision as to what’s important to its residents, and fully backs the projects with an unlimited tax liability pledge. Most bonds backed by a general obligation pledge have been approved by the voters. The second largest is education at 25.3%. Adding these two categories together means over half of the bonds issued are being used for schools or projects approved by its citizens. Let’s go one step further and look at what percent of the issuance is being used for “essential services.” Bond proceeds for electric power and water/sewer utilities are equal to 14.6% of the issuance. Adding this category to the previous two raises the total to over two-thirds of all bond proceeds that are either approved or provide a service that is considered “essential.” Now, for some, whether we count housing, transportation and healthcare as “essential” is open for debate. Yet I think most local governments would tell you they have to provide it, and in some cases the federal government has mandated it. Let’s just call them “somewhat essential”. Adding in this final category to our running total, 91.8% of all bonds issued by municipalities fund projects deemed at least somewhat essential to its citizens. So it would be difficult to argue that this financing vehicle is not good for its citizens.

So there you have it: a market that is small and regionally focused, provides essential services, strongly backed financially by its residents, legitimately serves the population, and caters to individual investors. More specifically, over 73% of investors are individuals buying an average amount of $300,000, with 60% of the projects having above average credit quality strength. Plus, over 90% of the proceeds are being used for projects of importance to the community. Now I don’t know about you, but that is what I call doing efficient small town business for the common good!

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