It’s important to frame the developments in the broader financial markets over the last six to twelve months before discussing the municipal market’s continued ability to absorb issuer-specific credit events. Roughly a year ago, the United States’ triple-A credit rating was downgraded by Standard & Poor’s. This triggered one of the most pronounced and initially counterintuitive flights to quality in years. The Treasury rally continued to gain steam as the European debt crisis dominated market concerns.
To put these events into perspective, 10-year Treasuries were yielding between 260 and 270 basis points (bps) in early August 2011. During the first week of August 2012, yields had fallen roughly 100 bps. Municipal bond yields have followed suit, despite supply being up 65% year-over-year, albeit two-thirds of which were issued for refunding purposes.
Positive municipal market indicators
Today, municipal bond yields are also at near historic lows. The Thomson MMD scale shows 10-year triple-A bonds yielding 166 bps, down 97 bps from a year ago. Even more telling is the muni-treasury ratio. A year ago the 10 year muni-treasury ratio was approximately 96%. Last week that figure jumped to the 113% range – suggesting municipal bonds are an attractive allocation compared to Treasuries. Furthermore, broader market indicators show how well the municipal market is able to compartmentalize headline risk related to municipalities experiencing financial distress.
Low historic municipal defaults
Municipal Market Advisors (MMA) is an independent municipal research firm that produces market commentary. Recently the firm began reporting a weekly default trends article. In their July release, they reported that “par affected by first time defaults this year is just 0.02% (est. $750 million) of the outstanding municipal market; for the cumulative amount of par affected by first time defaults since 2010, just 0.28% (est. $10.36 billion) of the outstanding market.” As of July 31st, the report showed a total of 42 issuers experiencing first time payment defaults versus 68 and 83, over the same period in 2011 and 2010, respectively. The most fascinating statistic the report presents is that nearly 40% of the Chapter 9 bankruptcy filings since 2007 have occurred in California (8) and Nebraska (11).
Political will metric now critical
In last year’s mid-year credit review, we highlighted the cost of credit default swaps on 10-year bonds of three states: California, Illinois, and New York. We pointed out that when a state or municipality shows a willingness to raise taxes or curb spending, the market responds and insurance against a possible default becomes less expensive. The same can be said when a state or municipality shows an unwillingness to make responsible decisions. The cost of insurance on a 10-year State of California bond was roughly 180 bps in August 2011. On August 6th, 2012, the cost was 240 bps. Similarly, insurance on a 10-year State of Illinois bond cost just less than 200 bps in August 2011, but 282 bps in August 2012.
Willingness to honor financial obligations is perhaps the latest development in municipal credit. Historically, most distressed municipalities suffered from projects gone awry. Certainly there are examples of those types of issuers today, but more and more the municipal market is faced with issuers damaged from the compounding effects of poor financial management. Long before certain administrations contemplated their willingness to pay bondholders, they demonstrated an unwillingness to restore structural balance to operations and sensibly approach labor negotiations. The ex post nature of the evidence is what makes incorporating “willingness to pay” into municipal market analysis such a considerable challenge. The concept itself is intangible, can change as quickly as administrations change, and frequently requires investors to predict whether elected officials will opt for fiduciary responsibility or short term self-preservation. The solution for bondholders, even in light of attractive buying opportunities, is to remain highly selective and continue thorough due diligence practices.
Renewed debt ceiling debate looms
In the near term, or until economic conditions for municipal governments improve, expect pockets of distressed municipalities to take their chances in bankruptcy court or with some form of state fiscal oversight committee, where applicable. Moreover, there are two events to watch closely as it pertains to municipal credit quality – the mandatory spending cuts at the federal level and revisiting of the US debt ceiling. Interestingly, the dialogue and fiscal conditions surrounding both events exemplifies the struggles occurring at the state and local government level. Governments have bills to pay and services to provide, but have limited resources to do so. The outcome of those events will undoubtedly impact the bottom line for taxpayers and municipal governments alike.
Justin Formas, CAIA
Director of Credit Research
Bernardi Securities, Inc.
August 13, 2012