INSIGHTS

On August 18, 2014

Viewpoints from AAM - The Road to Navigating the Changing Municipal Bond Market – Including Potholes

Municipal bond participants are following closely the state of affairs in Puerto Rico and Detroit. In each case the outcome and changes in the municipal market landscape will likely be driven as much by politics as pure economics. Historically, the security of certain classes of municipal bonds – whether an Unlimited Tax or Limited Tax General Obligations, essential purpose revenue bonds, general revenue bonds, toll roads, hospitals, COPs (Certificates of Participation), etc. – has, generally speaking, been clearly evident. Pending the outcome of the Detroit and Puerto Rico situations, this pecking order of the credit security of a particular class of bonds may become a bit scrambled.

In times of uncertainty, it would be easy to say, “Do not buy anything near Detroit or just buy names such as North Carolina State General Obligations.” However, historically, that would not be the wise course of action without mentioning the potential value in all the names in between. The real opportunities in the municipal markets are finding the good names that provide good value that are between the extremes of the credit market.

An investor can certainly count on the rating agencies if they so choose, but a lot has been written about how the rating agencies missed the boat in the last credit crunch period. More bothersome, in my view, is this Bloomberg article, S&P Widens Lead Over Moody’s as Bond Upgrades Surge: Muni Credit. The article points out that there is a difference between how the rating agencies evaluate bonds based on new methodologies and that the S&P’s (Standard & Poor’s) metrics generally results in a higher rating more times than not versus the other major rating services. The article points out, “while Moody’s cut more municipal ratings than it lifted in the first half of the year – a trend that has held for 22 quarters – S&P says it upgraded 1,255 public-finance issuers and reduced 410.” The article goes on to say that some municipal bond issuers, even though they have ratings from more than one rating service, may only use the more favorable rating; the higher the rating the lower the borrowing costs, i.e., lower interest rates paid to the investor. Additionally, there are differences in what the rating agencies charge. That coupled with the difference in the ratings themselves may drive issuers to a more favorable rating agency based on the higher rating and lower costs.

Hmmm. It does make one wonder whether the other rating agencies will change their rating criteria in order to compete and not lose market share. I can understand how this may make investors think hard about buying an issue based solely on ratings.

There are many ways to determine if a municipal bond is a good investment. Generally, I think the investor needs to know the issuer, the city, state, laws, local politics, and the trends of unemployment, tax base, population growth, pension obligations, etc. Certainly the ratings from the rating agencies should help. Another major consideration is the purpose of the bond. Is it a general obligation, essential purpose revenue such as water and sewer or some type of other revenue such as hospital, or toll roads? Who is paying the bills and what type economic condition are bill payers in?

Another very important and timely consideration given Detroit and Puerto Rico is the ultimate security of the bond in the case of default. An extreme example of this was a municipal issuer of a Certificates of Participation revenue bond where in the event of default from a non-appropriation of funds, the security for the bondholders was ownership of the city swimming pool. Maybe I’m wrong, but I do not have a big picture of the bondholders taking turns working a ticket booth in the summertime.

In this world of point-and-click trading, there just may be a greater need for guidance and advice now more than ever from professionals in the municipal field, whether that guidance is from municipal salespeople, traders, credit analysts or from fee-based money management where the decision making is delegated to the money managers.

It would be easy to take the route of buying only clean, high-grade credits in economically thriving areas, but these types of municipal bonds historically are not as plentiful and given their gilt-edge credit worthiness, the yield is relatively very low. The key is to be comfortable with the credit and comfortable with the economic and political environment of the issuer while receiving a fair rate of return.

CRN: 2014-0814-4343R 

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