In the aftermath of the 2008 credit crisis, the municipal bond market experienced a profound shift in risk dynamics. Today, the municipal landscape is dispersed, fragmented and localized. Assessing creditworthiness and the relative valuations of credit spreads matters more than ever. PIMCO believes this new paradigm has implications both for the composition of the municipal marketplace and the process investors should use to evaluate the opportunities that we see amid the market’s transition.
Transformation
In the years leading up to the credit crisis, the perception of safety in the municipal bond market had driven investors to the point of complacency. This was understandable given the extremely low rate of defaults in the sector and the widespread use of default insurance to enhance the credit quality of new issues. In fact, in each of the five years prior to and including 2007, more than 50% of primary issuance was insurance wrapped. The upshot: The majority of the municipal market was viewed as a rates-based, commodity-like space, with a large portion of the market AAA rated, and the market had very little yield differential for similarly structured securities.
Put another way, creditworthiness was not a primary factor in muni sector analysis or valuation. The credit crisis significantly altered this dynamic. So-called monoline insurers stumbled, with their insurance ratings falling below AAA, and some have disappeared from the muni market altogether (See Figure 1). Meanwhile, the negative fiscal impact of the recession upon state and local municipal entities – stresses not seen since the Great Depression – introduced additional credit pressures across the entire market.
Today’s market Today, the critical variables in the muni investment process are no longer just the absolute levels of rates, supply and demand conditions, and the global relative value of the tax-exempt market. Now, the primary emphasis in security selection must be placed upon creditworthiness and the relative value of credit spreads within the market.
At the same time, the post-crisis municipal market is large, fragmented and localized – and big: Total muni debt outstanding is up nearly $1 trillion since the end of 2004 to over $3.7 trillion at the end of 2011, according to the Bond Buyer, a trade publication. The range of offerings has expanded as well: Some 20% of all bonds issued in 2009 and 2010 came in the form of taxable Build America Bonds, or BABs, which were issued under a government program ended in 2010 and that incentivized issuers with a 35% federal subsidy on interest paid on such securities.
In such a large and disperse marketplace, we believe investors with the resources and process in place to conduct proprietary credit research may have a strong competitive advantage.
Investing in a muni credit market
The issue of credit is important in two distinct ways. The first is in evaluating an issuer’s probability of default. The second is determining the appropriate credit spread that should be applied to the issuer’s debt, given the corresponding credit rating and market environment.
Statistics for the municipal market as a whole suggest a low probability of default (Figure 2). As many issues are backed by broad tax bases or essential service revenues, credits in the market have historically been secure. In addition, sovereign-type credit exposure shifts credit risk to the governmental segment of the economy, where debt service is usually secured by a municipal monopoly or general obligation supported by a large tax base. Although the municipal market experienced an uptick in defaults in 2011, a vast majority of these events were sector specific and did not indicate an increased systemic risk to the creditworthiness of the overall municipal market (see Figure 3), we believe.
This is not to suggest that monitoring the overall industry’s default probability warrants complacency. The negative effects of the recession continue to challenge the market and the issue of significant future liabilities in the form of pension and medical benefits to public employees will stress credit conditions throughout the municipal industry in the future. Individual bond selection, coupled with a strong understanding of market and economic forces, remain key.
Regarding spreads, the credit spread at which a bond trades relative to other bonds and vs. the market as a whole has become a critical variable in the investment process in today’s transformed municipal market. By tracking and comparing the spread of specific bonds to various indexes both before and after the credit crisis, we can see the impact that credit and credit spreads can have in the proper valuation of a bond.
The chart (Figure 4) illustrates this point. It compares the yield of an AA-rated New York City revenue bond to the Municipal Market Data (MMD) AAA Index, a proxy for high-quality municipals, and the 30-year U.S. Treasury, from 2006 through 2011. As shown, yield differences were narrow until 2008, at which point the crisis began to substantially widen spreads not only to the U.S. Treasury rate but to the municipal AAA index as well. Spreads have also been more volatile, as muni issues have become increasingly sensitive to credit risks, negative headlines and to the spreads of other similar bonds in the marketplace.
These inefficiencies create opportunities for the informed municipal investor. When the spread on a bond more than compensates an investor for its underlying risks, the bond becomes an attractive candidate, PIMCO believes. While increased volatility in the municipal market has its challenges, it also provides good opportunities to find mispriced securities.
Supply and demand imbalances
Supply and demand technical factors also play a critical role in municipal bond valuation. The credit crisis eliminated a number of marginal demand providers from the market: leveraged municipal hedge funds, foreign bank municipal carry trade strategies and U.S. municipal broker-dealer proprietary investors. Today, once again, households have become a primary supplier of demand, either through direct bond ownership or via mutual funds. As a result, the demand side is comparatively narrow, sensitive to retail trends and potentially overwhelmed by heavy supply.
This decreased marginal demand has made supply and demand imbalances in the market more pronounced. In periods of heavier-than-normal new issuance, when supply far outstrips traditional investor demand, the market tends to cheapen to a far greater extent than during similar periods in the pre-2008 environment. These surges in supply tend to cheapen the market to the point where valuations induce crossover investors to take advantage of the relative widening in spreads to other investment alternatives. These investors act as a relief valve when market inefficiencies appear, but often only after a substantial cheapening has affected the overall market.
The impact of a surge in primary supply is demonstrated by Figure 5. In the fourth quarter of 2011, new issue supply increased 33% from third-quarter levels, according to Bond Buyer, and the MMD AAA municipal 30-year curve cheapened from 3.54% to 3.86% and its ratio to the 30-year U.S. Treasury widened from 110% to 133%. In addition, so-called municipal spread product – those bonds rated below AAA and which trade on a spread basis to the AAA municipal curve – widened substantially as well.
Conclusion
The 2008 credit crisis proved to be a turning point for the municipal bond market, transforming a rates-based bond sector into one in which creditworthiness plays a dominant role. To succeed in this market today investors must take into account a wide range of factors, including:
- Impact of in-state taxation rates for the bondholder and its influence on trading levels
- Level of absolute rates and their impact on flows
- Relative value of municipals to other fixed income markets
- Supply and demand technical factors within the market
- Newly heightened emphasis upon issuer-specific credit quality, along with the impact on the proper corresponding credit spreads.
PIMCO believes that this new paradigm has put a premium on credit research for proper bond valuation and protection of principal. We think those investors who can draw on a process that is rich with research resources can find opportunities for attractive return potential.
Joe Narens, Sean Cameron and Sam Weitzman contributed to this commentary.