Baird’s Pierson Discusses Changing Conditions in the Municipal Bond Marketplace

August 2010
Warren Pierson We have been saying for a while that there is a changing landscape developing in municipal credit. While we believe the changes are proving to be significant, credit challenges in the municipal market have lagged the nearly unprecedented challenges experienced in the corporate market [earlier] in 2008. Revenues for many corporations fell sharply and nearly immediately as the credit crisis developed in late 2008, but softness in municipal revenues have taken a year or more to surface. As investors were seeing conditions in the corporate market improve dramatically in mid to late 2009, many concluded that the worst for the bond market was behind them. Accordingly, many investors were caught off guard and by surprise to see that conditions for many municipalities were just starting to deteriorate at that same time.

This natural lag in the decline of municipal revenues (i.e. property taxes, sales taxes and income taxes) resulted from:
  1. lower property values,
  2. softer consumer spending and
  3. higher unemployment/lower wages.

Used to decades of steadily-increasing top line revenues, municipalities have struggled to balance budgets as the swift decline in revenues has often resulted in structural deficits. Many one-time fixes (e.g. selling buildings) have been applied as stop-gap measures to balance budgets for a particular year, but persistent structural deficits are becoming more difficult to address as revenues remain soft. While outright reductions in expenditures may be necessary, cutting spending is socially unpopular and often politically difficult to achieve.

These challenges confronting the municipal market have several implications:
  • Lower ratings (and corresponding price declines) in response to weaker financial positions. Even in historically stable sectors (e.g. GOs), new financial challenges could result in downgrades. In 10-year maturities, the difference between yields on AA-rated issues and A-rated issues is approximately 60 bps. A downgrade from AA to A could mean a price decline of up to 5%. BBB yields in the 10-year range are over 100 bps higher than yields on A-rated issues, leading to a potential price decline of 8% or more for a downgrade from A to BBB.
  • Increased potential for defaults. As revenues decline, some issuers may not be able to service their debt. This is a greater risk to bonds with more narrow revenue sources (e.g. a parking structure or convention center), but even some GO issues could be at risk if financial conditions are severe (e.g. fast growing community that financed and built schools in expectation of continued population growth and expansion that didn’t materialize, or established community that has experienced severe declines in property value, high unemployment and declining population). While we believe the probability of widespread defaults is low, issues with limited, questionable or contingent revenue sources are clearly at greater risk and we have already seen the market place a liquidity premium on such issues. We are also concerned that issuers between a rock and a hard place could look to bond holders for concessions. If confronted with the options of 1) raising taxes on already burdened constituents, 2) cutting social services or programs to people at risk or 3) laying off teachers or other municipal workers, asking bond holders to “share in the pain” could be viewed as part of a solution for the greater good of all. Historically there has been a very strong stigma associated with defaulting and hopefully that will persist. However, the stigma will fade if more issuers choose to take this path.
  • Price volatility. As the market prices in these different [perceived] risks, one could see significant price volatility on individual issues. We have seen several [intermediate] issues trade in the secondary market as much as 5 points below where the pricing service had been pricing them. As a result of the posted trades, the pricing service adjusted its prices.
  • Illiquidity. Due to the market’s concern about the potential risks, liquidity in certain issues can be limited and transaction costs can be significant, particularly on smaller pieces.
Given the changing landscape, we recommend that investors exercise caution in the municipal market. The municipal market has long been considered a close second to Treasuries by investors in terms of quality. While still a high quality market overall, the municipal market has changed in recent years. Many municipalities find themselves in unchartered waters, and investors navigating these current waters with the same strategies they have used in past decades could be in for some unpleasant surprises.

We caution investors against going too far down in credit quality or too far out the yield curve. We believe higher quality, intermediate issues offer investors the bulk of the value in the market yet provide significant protection from downside risks. Diversification is key. Building a typical bond ladder with 10 or 20 issues results in 5-10% exposure per issue – problems with even one holding could have a significant impact on the overall portfolio. We firmly believe that most investors are better served by using a fund where exposure to credit risk of individual issues is typically limited to 1% of the portfolio or less.