Stating the obvious.
Mostly everyone involved with the municipal bond market will concede that the market has reached an inflection point. Two different (but not mutually exclusive) narratives have emerged, however, for characterizing the nature of this inflection point, its attendant risks, and policy implications.
The first narrative (let's call it the "credit narrative") "“ which, to me at least, has been most rationally articulated by bond fund giant Pimco "“ is that the muni market is transitioning from an interest rate space to a credit space, such that investors must evolve and begin pricing in a meaningful chance of default. Although credit concerns are presently a novelty for the mainstream media, which tends to blow them out of proportion, something along the lines of what Pimco described has been unfolding since the beginning of the bond insurance industry's downward spiral years ago, and certainly since the financial crisis. One can see evidence of a shift in persistently wider credit spreads and in a growing preference for munis supported by a dedicated revenue stream (when compared to general obligation bonds). I explained why a preference for bonds supported by special revenue pledges would increasingly make sense in my earlier posts on default and bankruptcy.
(Please note that the credit narrative I have presented here should not be confused with Meredith Whitney's infamous prediction that there will be 50 to 100 significant defaults totaling hundreds of billions of dollars within the year. Most market participants have challenged the credibility of her forecast, to put it mildly, and Whitney herself has admitted that she basically pulled those figures out of thin air "“ something I hope the Securities and Exchange Commission considers when evaluating her NRSRO application.)
The second narrative (let's call it the "structure narrative") suggests that for decades municipals on the long-end of the curve have been supported by a patchwork of transitory market influences (such as the popularity of variable rate debt instruments and leveraged muni arbitrage funds), and most recently, the Build America Bond (BAB) program, which was established by the American Recovery and Reinvestment Act (i.e., federal fiscal stimulus legislation) in early 2009 and expired at the end of 2010. (Interested parties would be well-served to read what Dan Seymour has written for the Bond Buyer on structural concerns in recent weeks.)
It is unclear whether these narratives "“ to the extent that they are accurate reductions of market behavior "“ will simply reinforce an otherwise organic trend toward higher interest rates, or if they communicate something meaningful about the overall functionality of the market. This is unlikely to become a settled issue until some significant level of new supply tests the strength of the muni market for a prolonged period of time. Many critics of the BAB program assert that the program incentivized issuers to assume heavier debt burdens (with the logical corollary that issuers are now less creditworthy). In reality, the expiration of the BAB program pulled new supply forward, which has resulted in dramatically lower levels of debt issuance this year. So far, only $30.8 billion of negotiated and $12.3 billion of competitive deals have been sold. During the same period last year, $97.3 billion of total fixed-rate debt was issued (Bloomberg Municipal Market Brief, 3/30/2011). The amount of new debt issued this year will probably not be anywhere near where it was last year for various reasons, including political pressure and the fact that many issuers will be at or approaching their self-imposed debt limits until revenues fully recover. In fact, there is a good chance the amount of new debt issued this year will be the lowest in over a decade.
With that said, new issuance is typically much higher in the 2nd quarter given issuers' budget cycles. We could potentially be headed for the first major test of the muni market since the BAB program expired, and I expect the folks who view the market solely through a credit lens to overlook or misrepresent it. It is a truly bizarre thing to see various market observers obsess over governments' creditworthiness, and to see federal policymakers take this concern and run with it, because they are missing what is currently the most significant obstacle to price discovery in the muni market. The expiration of the BAB program reestablished a longstanding mismatch between supply and demand (even at lower levels of issuance) and this mismatch remains unaddressed.
Although the BAB program may have been sold politically as a means to create or preserve jobs (just like literally every other piece of federal legislation introduced by either party in recent years), anyone who understands the mechanics of the muni market recognizes that this was hardly the actual purpose of the program. The purpose of the BAB program, in fact, was to prop up munis amidst a period of intense distress within the financial markets generally, during which the investors that had traditionally participated in the muni market either had been sidelined by their unique capital constraints or evaporated all together. (Pause for a moment and reflect on the level of uncertainty in the capital markets during the 1st quarter of 2009 when the legislation was introduced.) The program opened up the muni market to new investors by changing the nature of the mechanism by which the federal subsidy for municipal debt is delivered. That's all. It is true that muni issuers tapped the market for record amounts during this period, but that is what happens when (1) demand for government services increases exponentially during a severe economic downturn, forcing governments (not unlike the federal government) into the capital markets to a larger extent, and (2) policymakers give a useful program a completely arbitrary expiration date. (For background information on this point, I have gone to great lengths in prior posts to demonstrate that public debt burdens have been relatively stable when compared to issuers' tax bases and to differentiate between policy and debt crises.)
Those who do not recognize that the expiration of the program pulled supply forward also tend to miss the fact that the circumstances that made the BAB program necessary in the first place have not changed. What follows is an explanation of how the expiration of the BAB program fits within the structural market narrative.
The interest income derived from state and local government bonds has been exempt from federal taxation ever since the US Constitution was amended in 1913 to allow Congress to levy personal income taxes. (Although some debt is issued in the muni market on a taxable basis "“ such as some private activity bonds and pension obligation bonds. Fleshing those tax issues out, however, would require an epic digression, even by my standards for verbosity.) Because the federal government is forgoing the opportunity to tax this particular type of income, the tax-exemption is a de facto federal subsidy on state and local government borrowing and the expensive, large-scale public projects that are typically financed with muni bonds. (I doubt most people would find the social benefit here controversial.) Municipal debt typically yields less than that of other kinds of credits because investors are willing to accept a lower yield in exchange for the tax benefits. Although lower yields reduce issuers' borrowing costs, the exemption is also a constraint on investor participation in the market, such that the market is dominated by wealthy retail investors who benefit from sheltering their income from taxation.
What's not to like about this arrangement? Well, state and local government borrowers tend to issue long-term bonds so that their debt burdens do not crowd out their programmatic priorities or require them to levy additional taxes (much like a homebuyer would prefer to finance a house with a loan that accommodates their cash flow constraints and reflects the long useful life of the asset, rather than with a short-term note), but wealthy retail investors would prefer not to lock up their money for a long period of time. Although the way municipal bonds have been traditionally structured makes sense from the issuer's (and thus the taxpayer's) perspective, it is wrong to assume that there will always be sufficient demand for the debt.
The muni market has not had to deal with the mismatch between supply and demand to date (or at least not for an extended period) for three reasons: (1) Wall Street innovations offered solutions to the problem; (2) muni arbitrage funds absorbed a considerable amount of long-term debt; and (3), shortly after (1) and (2) collapsed during the financial crisis in 2007-08, BABs were introduced. I'll explain these points in turn.
The muni market could have likely avoided some extremely problematic financial innovations if a viable program for issuing taxable bonds had existed. In the early 1980s, muni issuers began using two types of variable rate debt, auction rate securities (ARS) and variable rate demand obligations (VRDOs), as an alternative to traditional fixed rate bonds. ARS are a type of security that has a long term (typically 20+ years) but bear interest at a rate established at short-term intervals through an auction process (or a penalty rate specified in bond documents in the event that there are insufficient bidders to cover the amount of securities offered for resale). VRDOs are similar to ARS in the sense that they reset at short-term intervals, but investors' liquidity stems from a put feature. With VRDOs, investors may put the bonds back to the trustee or tender agent (effectively force the bonds to be repurchased at par plus accrued interest) with little notice. Since most issuers would not easily be able to accommodate an event where substantially all of the debt suddenly could not be successfully remarketed, the issuer pays a commercial bank to support the debt through a letter of credit or standby bond purchase agreement. According to the Bond Buyer, 29% of all municipal borrowing from 2002 to 2007 was in the form of ARS or VRDOs.
There has certainly been no shortage of commentary regarding the grotesque denouement of the ARS market (in fact, I am going to assume you already know how the story ends and not repeat it here) and potential issues surrounding the extension of credit facilities by commercial banks to support VRDOs. Few people, however, mention why these complex instruments became popular in the first place. To be sure, some muni market issuers wanted or required variable rate exposure (issuers of student loan ABS, for example). Also, although it complicates government issuers' budget processes, variable rate debt exposure can be perceived as a positive from a portfolio management standpoint. Issuers who actually wanted a fixed rate coupled their variable rate debt issues with interest rate swaps to achieve a synthetic fixed rate. (This, of course, meant they assumed a litany of other risks.)
But the main reason these structures suited the muni market was that they offered a means of working around the supply / demand mismatch by allowing borrowers to issue debt with nominal long-term maturities and investors to buy debt that (in theory, at least) mimicked short-term debt with respect to interest rate risk and liquidity. Issuers and investors both had the commitment structure they desired until the markets as a whole ceased to function properly. Banks also had significant new sources of fee income (for the credit facility and task of remarketing the debt, for example). Had there been a taxable option in place, issuers could have just sold traditional fixed rate debt to investors that wanted that specific kind of exposure, but may not need the tax benefits of the debt. Instead, issuers and their bankers were left trying to tailor their debt to the types of investors that were available.
Whereas the use of variable rate debt instruments "found" demand for the long-end by disguising short-term investors as long-term investors, tender option bond programs (TOBs) created shadow demand for long-term municipal debt through the use of leverage. TOBs were fairly similar to structured investment vehicles (SIVs) in strategy, in the sense that they essentially involved issuing short-term securities at low interest rates and purchasing long-term securities at higher interest rates, with the spread minus expenses going to investors as profit. Here is a (very) rough sketch of how a TOB program works:
A [hedge] fund manager invests contributed capital in high-quality assets [i.e., muni bonds] pledged as collateral to a dealer who forms a trust and issues two classes of securities: senior short-term floating-rate notes [VRDOs], and junior notes called residual certificates. The proceeds from the sale of the short-term notes are used to purchase additional long-term municipal bonds thus leveraging the residual certificate holders' exposure to the long-term municipal bonds held in the trust.
The interest rate paid by the trust on the [VRDOs] is reset weekly and is equal to the short-term municipal yield benchmark less a market-determined spread"¦ The junior residual certificates are retained by the hedge fund [or are sold to investors who do not have interest in underlying collateral] and pay an interest rate equal to the difference between the interest rate on the underlying long-term municipal bonds and the interest paid to the short-term, senior note holders, less the trust's expenses"¦
Hedge funds used interest rate swaps to hedge both the long-term and the short-term interest rate risks.
Ideally, this arrangement would have protected the fund from a situation where market yields for muni bonds increased (thus causing the value of the bonds held in the trust to fall) or where short-term yields increased (thus reducing investors' net interest). However, during the financial crisis, the relationship between muni bond yields and swap rates became unhinged. The funds suffered significant losses as declines on the muni debt were not offset by gains on the swaps.
There are two points to be made here. First, due to their use of leverage, TOB programs provided a considerable source of demand for long-term munis. According to the Bond Buyer, "at their peak, [TOBs] had grown to anywhere from $300 billion to $500 billion, soaking up as much as a quarter of annual municipal bond issuance some years." Second, that demand is no longer around.
Compared to the use of variable rate debt, the interest rate derivatives associated with it, and TOBs, the BAB program was an elegant and stable solution to the supply / demand mismatch problem in the muni market. There are certain kinds of investors who are native purchasers of long-term debt, like pensions and some foreign investors. However, the tax-exempt status of munis is a liability for these issuers, not an asset. These investors do not need the tax benefits and would find munis offering lower interest rates unappealing. With the BAB program, governments issued taxable bonds and received the subsidy directly from the federal government in the form of 35% of the issuer's interest cost. This program likely could have worked out better (from the federal government's standpoint) if the amount of the subsidy were set lower and if the federal government's own financial situation were more flexible. Of course, this also presumes that federal policymakers understand the actual purpose of the program, and they largely do not.
I realize that I have pushed every populist button extant with the market vocabulary employed in this post ("financial innovation," "shadow demand," etc.), which should prompt the facile and formulaic response populists have to everything related to the financial markets (not unlike Pavlov's dogs). If you have read this post and concluded that these innovations and investors were merely artificial by-products of the era of easy money and that the BAB program was merely a bailout for the muni market when they collapsed (not unlike federal government intervention in the housing market), then you have missed the point of this discussion entirely. One major distinction between the housing and muni markets is that the muni market is not a “natural” market by virtue of the taxation issues involved. The tax status of municipal bonds dictates investor participation prior to any other characteristics of the debt.
At any rate, the moral of this story is simple. There is not much left to support the long-end of the market at this point. If supply actually does spike in the 2nd quarter, things could get more than a little interesting.
I think I understand your point, but, well, I’m naive and prone to persuasion by populist arguments. Anyway, with the institutional demand for AAA debt being what it is (and at least some munis not having the convexity risk of MBSs) and with the finance sector as powerful as it is, it’s odd to me that there hasn’t been a successful push to change the nature of the federal subsidy. So while I believe that financial innovation solved a difficult problem, I’m interpreting this discussion to mean the solutions were hardly optimal.
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