Municipal bonds sold off in 2008, then staged a comeback in the first three quarters of 2009—but lately they’ve been more volatile than municipal bond investors generally expect or want. What’s creating the volatility—and what are the potential implications for municipal bond investors?
Municipal budgets are under pressure
Let’s start with the most basic explanation for the municipal bond market’s recent volatility: reduced tax revenues.
State and local tax revenues have significantly decreased during the recession, according to the Nelson A. Rockefeller Institute of Government’s State Revenue Report issued in October 2009. In fact, according to the report, state tax revenue declined 9.2% year-over-year in June 2009.
As a result, at least 36 states are anticipating budget deficits in 2011, according to a September 2009 report from the Center on Budget and Policy Priorities (“New Fiscal Year Brings No Relief From Unprecedented State Budget Problems”).
Moreover, these shortfalls are significant. Of the 30 states that offered estimates, the shortfalls represent $74 billion—equivalent to 15% of their budgets. Ouch!
If the economic recovery is slow, with the labor market lagging, as many economists expect, this pressure on municipalities could continue.
As a result, many clients are asking me if I think a lot of municipal bond issuers will default. One could argue that they won’t, since state governments must balance their budgets. This could lead them to address their financial problems now, leading to fewer defaults than might otherwise be expected. But perception accounts for much when it comes to investing, and the mere possibility of default has contributed to the volatility in the municipal bond market.
The demise of municipal bond insurers has reduced the availability of prime-rated bonds
Naturally, in troubled times, many investors seek investments they perceive to be less risky—such as bonds that are awarded high ratings by the credit ratings agencies.
Credit rating agencies (such as Moody’s, Standard & Poor’s, and Fitch) assign letter designations (such as AAA, B, CC, etc.) to bonds to indicate their credit quality. This bond credit rating assesses the credit worthiness of the municipality’s debt, or its ability to repay interest and principal in a timely manner. The higher the rating, the lower the probability of default.
But the highest-rated bonds, called prime bonds, are in shorter supply, because fewer of them are insured. That’s a recent change. In the buildup to the financial crisis, more and more new municipal bond issuance was insured—approximately 60% in 2007 compared with only 3% in 1980, according to WM Financial Strategies estimates as of 9/30/09. But then municipal insurers experienced losses (and respect) during the financial crisis. In the secondary market, most bonds that had been issued as “AAA-insured” lost their prime rating. And in the primary market, bonds that would previously have been issued as AAA-insured started coming to market with the underlying rating of their issuers (such as AAA, AA, etc.).
Going forward, the result could be increased supply (and reduced pricing) for below-prime bonds, and reduced supply (and increased pricing) for prime bonds. But investors are still trying to understand what to make of this situation, and as they do, the municipal bond market has been choppy.
BABs are attracting new types of investors
Finally, we can’t forget about Build America Bonds—a program created under the American Recovery and Reinvestment Act of 2009 (ARRA) that allows municipalities to issue federally subsidized bonds called Build America Bonds (BABs).
Because BABs generate income that is subject to federal taxation, they have higher coupons than traditional municipal bonds do.
That’s made them attractive to a new type of buyer—tax-exempt organizations such as endowments, foundation and pension plans. These organizations had never been interested in municipal bonds before because municipal bonds’ tax-exempt status offered no benefit, given that these organizations were themselves tax-exempt investors.
This new market has led many municipalities to issue BABs instead of traditional municipal bonds—and that, in turn, appears to be reducing the supply of (and increasing the demand for) traditional municipal bonds. And that’s helped the market rally.
What does it mean for municipal bond investors?
As we’ve seen, changing supply and demand ratios as well as concerns about credit risk have driven the recent volatility in the municipal bond market.
On one hand, the compensation municipal bond investors receive for bearing credit risk could be high, especially when compared to levels prior to the financial crisis. On the other hand, the risk of default is real, and should not be discounted.
In my opinion, however, there is a low likelihood that a meaningful number of investment-grade municipal bond issuers will default.
When investing in municipal bonds in today’s volatile market, the key then may be due diligence. I think analysis of municipal issuers is more important than ever, so investment managers must be disciplined—and investors must be prudent.
If you’d like to learn more about investing in municipal bonds, please contact us at (800) 541-7774 or email
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