UnderstandingRiskintheMunicipalBondMarket

JeffreyD.Slater,CFA
MuniCrestInvestmentManagementCompany,LLC
February15th,2011

ExecutiveSummary
Themunicipalbondmarkethasrecentlycomeunderattackinboththefinancialandpopular
pressasahighriskassetclassripeforwidespreaddefaultsandmaterialcapitallossesby
investors.Wedisagreewiththesebroadgeneralizations,notethattheyarebeingmadeby
thosewithlittle,ifany,experienceintheassetclass,andwillmakethecasethatthecurrent
dislocationinthemarketactuallypresentseducatedinvestorswithauniqueopportunityto
entertheassetclassatcheapvaluations.Wedefinefourkeyriskcharacteristicsinherentin
municipalbondsandaddresswhethercurrentinterestratelevelsadequatelycompensate
investorsfortheserisks.Weconcludethattheassetclassisoversold,currentinterestrate
levelsmorethancompensateinvestorsforthecreditriskstheyincur,andthatinterestraterisk
managementwillbetheprimarydriverofreturnsin2011andbeyond.
CreditRisk
Creditriskistheriskthatabondissuerwillbeunabletomakeprincipalandinterestpayments
inatimelymanner.Themarketpricescreditriskbyattachingayieldpremiumtoeachbond
issuebasedontheperceivedprobabilitythattheissuerwillmakeitsdebtservicepayments.
Thosebondissuesdeemedtohavealowerprobabilityofmissingadebtservicepaymentwill
haveaverysmallyieldpremiumaboveandbeyondtheriskfreerate,whileissuesperceivedto
bemoreatriskwillhaveahigheryieldpremiumovertheriskfreerate.Thedifferencebetween
theyieldonabondwithacreditriskpremiumandtheriskfreerateisdefinedasaquality
spread.Inthemunicipalbondmarket,theacceptedmeasurefortheriskfreerateisthe
tripleAscalepublishedbyMunicipalMarketDataeverydayat3P.M.(theMMDscale).While
theMMDscaleisfarfromperfect,itrepresentsanaverageofwheretheuniverseoftripleA
papermayhavetradedonthatparticulardayandisacceptedbythemarketplaceasthe
benchmarkscale.PortfoliomanagersandtraderstrackqualityspreadsrelativetotheMMD
scaleverycloselyandusehistoricalaveragesasagaugeforwhethercurrentspreads
adequatelycompensateaninvestorforincurringcreditrisk.Whenwethinkaboutcreditrisk,
wethinkofitintwoways:DefaultRiskandDowngradeRisk.DefaultRiskistheriskthatan
investorwillnotreceiveinterestandprincipalbackfromtheissuer.DowngradeRiskistherisk
thatthecreditratingofabondissuewilldecrease,leadingmarketparticipantstodemandan
increasedqualityspreadforbuyingthebond.

Letusaddressdefaultriskfirst.Historically,themunicipalbondmarkethasbeenperceivedas
averysafeassetclass.Defaultshavebeenextremelyrare,andtheentireuniverseofmunicipal
bondshasalowerdefaultratethantheuniverseoftripleAratedcorporatebonds(seeFigure
1).Whentheydooccur,theyareconcentratedinthehousingandhealthcaresector,and
generallyhappentobondsthatneverhadaninvestmentgradecreditratingfromoneofthe
nationallyrecognizedcreditratingagencies.Thesearebondsthatwereperceivedasveryrisky
(HighYield),fromthegetgo.Thedefaultrateforbondsthatoriginallycametomarketwith
investmentgraderatingsisnearzero.Since1970,therehavebeenonlyfourdefaultsatthe
countyandlocallevel.Monetarylossesbyinvestorshavebeenminiscule.Notethatwhen
municipalbondsgointodefault,therecoveryrate,orpercentageoforiginalinvestment
returnedtoinvestors,averages66%ofparversus42%forcorporatebonds.Weknowthatpast
resultsdonotguaranteefutureperformance,andthatcreditriskcanchangeveryrapidly,aswe
onlyneedlookasfarbackas2008andseewhathappenedwithBearStearns,LehmanBrothers,
etc.Wefeelthatdefaultriskremainsextremelylow.
Figure1
CumulativeHistoric
DefaultRates
Aaa/AAA
Aa/AA
A/A
Baa/BBB
Ba/BB
B/B
CaaC/CCCC
InvestmentGrade
NonInvestGrade
All

Moody's
Muni
0.0%
0.1%
0.0%
0.1%
2.7%
11.9%
16.6%
0.1%
4.3%
0.10%

Moody's
Corp
0.5%
0.5%
1.3%
4.6%
19.1%
43.3%
69.2%
2.1%
31.4%
9.70%

S&P
Muni
0.0%
0.0%
0.2%
0.3%
1.7%
8.5%
44.8%
0.2%
7.4%
0.29%

S&P
Corp
0.6%
1.5%
2.9%
10.3%
29.9%
53.7%
69.2%
4.1%
42.4%
12.98%

Generallyspeaking,therearetwotypesofmunicipalbondsweinvestinforourclients,general
obligationbonds(GOs)andessentialservicerevenuebonds(ESRBs).Wehavenohousingbonds
inourportfoliosandonlyamodestexposuretothehealthcaresector.GOsarebackedbythe
fullfaithandcreditofthemunicipality,includingtheabilityoflevyaspecialpropertytaxshould
allothersourcesofrevenuefallshort.Noothertypeofsecuritypledgeequalsthisinanyother
fixedincomemarket.Ifthepropertyownerfailstopaythetax,theylosetheirhouse,butit
nevergetsthatfarinthemunicipalbondmarket.Municipalitieshaveabroadrangeofrevenue
raisingtoolsattheirdisposal.Theycanraiseincometaxes,salestaxes,anduserfees.Takethe
exampleoftheStateofIllinois,recentpressreportsinferthattheyareonthebrinkof
bankruptcy,thattheyneedaFederalbailout,andthatbreadlinesarealreadyformingonthe
SouthsideofChicago.Nothingcouldbefartherfromthetruth.Thestatesdebtburdenasa
percentageofGSPis3.8%.WhatIllinoisneedsisstrongleadershipandpoliticalcourage.After

yearsofignoringtheirstructuralbudgetdeficit(theyspendmorethantheytakein),theyfinally
agreedtoraisetheirincometaxratefrom3%to5%.Withavoteofthelegislature,andthe
strokeofthegovernorspen,stateincometaxrevenuesareslatedtoincreasebyupto67%.
NotethatthenewtaxrateisfarlowerthanCaliforniaandNewYorkincometaxrates,andwill
notforcepeoplefromthestatelookingforalessertaxburden.Municipalitieshaverevenue
raisingtoolsthatcorporationsdonothave.Illinoiswillcontinuetoexistasastate.Chicagoisa
hubofcommerceintheMidWest.Wealthlevelsarehighandtheirdebtburdeniswellwithin
reason.Inotherwords,theirunderlyingcreditfundamentalsaresound.Theysimplyneedthe
couragetomakethetoughadjustmentsanddealwiththeeffectsofahorriblerecession.Ona
broaderlevel,allstaterevenueswillincreaseastheeconomyrecovers.TheNelsonA.
RockefellerInstituteofGovernmentattheStateUniversityofNewYorkatAlbanypublishesa
StateRevenueReportonaquarterlybasis.Itisavaluableresourceforcreditanalystsand
everyquarterin2010showedrevenuegrowthforthestates.Whilethereisstillplentyof
groundtobemadeupfromthe2008recession,thenumbersareencouraging.
Theexpensesideoftheledgeralsoshowssomeflexibility,asmuchisbeingmadeofunfunded
pensionliabilitiesatthestateandlocallevel.Onestudyputstheunfundedpensionliabilityon
thestateandlocallevelat$3Trilliondollars.Municipalitieshavebeenunderfundingtheir
pensionsprogramsforyearshopingforarallyingstockmarket.Afteradecadeofflatreturns,
thenumbersarestartingtolookominous.Weagreethattherearereformsthatmunicipalities
musttake,thesituationisnotasbadasitseems.Thesehardtimeswillforcemunicipalitiesto
maketoughchoices,butletslookatthat$3Trillionnumber.Thefirstproblemwiththe
numberisthattheanalysisdiscountsthefutureliabilityattheriskfreerate,andnotatthe
historicalreturnsoftheplanassets.Planassetsareinvestedinstocks,highyieldbondsand
otheralternativeinvestments.Overtime,theseassetclasseshavereturnsfarinexcessofthe
riskfreerate.Discountingfuturepensionliabilitiesatmorepracticalhistoricalratesofreturn
onstocksreducesthe$3trillionunfundedliabilityto$700billion,stillaproblematicnumber,
butnotinsurmountable.
Municipalitiesneedtoaddressexcessesinmunicipalunioncontracts.Changesneedtobemade
todefinecontributionplansfromdefinedbenefitplans.InCamden,NJ,theMayorwasforced
tolayoffscoresofpoliceandfirefightersinJanuary.Facingastructuralbudgetdeficit,thecity
approachedtheunionwithaplantocutpayandbenefits,buttheunionrefusedand15%lost
theirjobs.Theunionvoted3001againsttheconcessions.Thisisabattleinawarthatthe
unionscannotwin.Municipalleaders,suchasGovernorChristieinNewJersey,arefinally
havingthecouragetotelltheirconstituentsthetruth:Thebuckcannotbepassedtothenext
administrationanylonger.Thetimetomaketoughdecisionsisnow,andsacrificemustbe
shared.Fewhavesympathyforthemunicipalunionsandtheirinabilitytofacethisnewreality.
WetaketheviewthatmunicipalleadersacrossthecountrywilltaketheleadformGovernor
Christie,andhavethecouragetomakethetoughdecisions.Astheeconomycontinuesto
recoverfromtherecession,municipalfinanceswillbecomestrongagain.

Onemorewordondefaultrisk,intheaggregate,debtserviceasapercentageofgovernment
expendituresaverageslessthan10%.MunicipaldebtoutstandingtoGDPisroughly16%,orjust
slightlyhigherthanthelongtermaverageof14%,notonerousdebtburdens.Cleary,any
municipalitylookingtocutexpenditureswouldloseaccesstothecapitalmarketsforan
extendedperiodoftimeshouldtheyfailtopaydebtservice,leadingtoasubstantialincreasein
theircostofcostofcapital.Investorshavelongmemories.Thosememoriesbecomelonger
whentheylosemoneyonaninvestment.Anymunicipalitythattriedtoshortchangebond
holderswouldbesorelymistakeniftheythoughttheycouldsellbondsagaininthismarket.We
thinkthatlosingaccesstothemarketsisdeterrentenoughtofocusontheother90%oftheir
budgetwhenmakingcuts.
Figure2:TheRewardForTakingCreditRisk

Downgraderiskisthemorepressingriskintodaysmarket.Whenevertheeconomygoesinto
recession,stateandlocalrevenuesdecrease,andbudgetdeficitsstarttomount.Therecent
recessionwasmoreseverethanmost,puttingunprecedentedstressonmunicipalities.The
ratingagencieshaveactedaccordinglyandhavedowngradedthosecreditsunderthemost
stress.Whenthemarketanticipatesadowngrade,theinvestorsdemandanincreasedspread
toownthebond.Anincreaseinspreadequatestoadecreaseinprice.Thefigureaboveshows
thespreaddifferencebetweensingleAratedbondsandthebenchmarkMMDcurve.Priorto
thecapitalmarketimplosionof2008,spreadswereverytightwithlittlevariationonamonth
tomonthbasis.Spreadexperiencepost2008isthenewnormal.Withthebondinsurance
industryonitslastlegs,thereisagreateruniverseofsingleAratedpaperandagreat
perceptionofcreditrisk.Shorttermmovementsinspreadshaveamaterialimpactonprice
returnsforaportfolio.Wehavealreadystatedthatwefeeldefaultriskintheinvestmentgrade
universeisextremelylow.Ourmaintaskincreditriskmanagementthenbecomestoavoid

thosecreditsthatwillfacespreadwideningandfavorthosethatwillseespreadtightening.
Manytimes,thebondswiththebestspreadtighteningprospectsarethosebondsthatyouare
hearingtheworstnewsabout.InmidJanuary,athirtyyearbondissuedbyCaliforniawas
yieldingmorethansimilarmaturitybondsissuedbyboththeRepublicofMexicoandthe
RepublicofColumbia(SeeFigure3).NotonlyistheCaliforniabondexemptfromFederal
incometaxes,butthewealthandeconomicindicatorsinCaliforniafarexceedthoseofthe
aforementionedsovereigncredits.Quitesimply,Californiaandmostothermunicipalbondsare
oversold.
Figure3:IrrationalPessimism
January15th,2011MarketActivity

Rating

BidSide

California6%of2039

A1/A

6.10%

Mexico6.05%of2040

Baa1/BBB

5.75%

Columbia6.125%of2039

Ba1/BBB

5.77%

InterestRateRisk
Wespentagreatdealoftimetalkingaboutcreditrisk.However,interestrateriskisthemain
riskinvestorstakewhentheybuybonds.Wheninterestratesmove,bondpricesmove.Bond
yieldsconsistoftwomaincomponents:Arealreturnandanexpectedinflationpremium.
Currently,thetenyearTreasuryisyielding3.60%.Assumingahistoricallyaveragerealrateof
returnof2.5%,themarketexpectsinflationtoaverage1.10%inthefuture.Inorderforratesto
increase,themarkethastoeitherdemandahigherrealrateofreturn,orexpectinflationto
rise.In2009and2010,ratesfellbecauseinflationwasnonexistent,andsomeinvestors
actuallywerepricinginpricedeflation.Strongereconomicdatainlaterhalfof2010spooked
investors,andincreasedfocusedwasplacedontheinflationpremiuminbondyields,sending
yieldshigher.Inthemunicipalmarket,yieldsmovebasedonanumberoffactors.Theprimary
factorarechangesinbenchmarkTreasuryrates.Thesecondarydeterminantofinterestratesis
simplytheforcesofsupplyanddemandwithinthemarket.Inthetaxexemptmunicipal
universe,supplyhasbeendepressedduetotheBuildAmericaBondprogram,whichsiphoned
supplytothetaxablebondmarket.Thatprogramexpiredattheendof2010leadingmanyto
believethattraditionaltaxexemptsupplywouldincreasein2011.Wedisagreewiththis
assessmentandfellthatbecausetheBABprogramwassettoexpire,someof2011Sissuance
wasbroughtforwardin2010.WeagreewiththeanalystsatBarclaysCapitalthatforecasta
newdecreaseoftaxexemptsupplyin2011.Lowersupplyshouldleadtohigherbondpricesand
loweryields,allelsebeingequal.
Whentalkingaboutinterestrates,weneedtobeclearaboutwhatrateswearetalkingabout.
InvestorshearthattheFederalReservecontrolsinterestrates,butthatisntreallytrue.The
Fedcontrolstwokeyrates:thefederalfundsrate,ortheratethatbankschargeeachotherfor
overnightsloans;andthediscountrate,ortheratetheFeditselfchargesthebanksfor
overnightloans.Overnightborrowingratesareonlyonesmallcomponentoftheyieldcurve.

Theyieldcurveisthegraphicdescriptionofinterestratesacrossthematurityspectrum.When
theyieldcurveissteep,longerratesarehigherthanshorterrates.Currently,theyieldcurveis
extremelysteepinboththetaxableandmunicipalbondmarket.Investorsarerewardedfor
extendingmaturities.Astheyextendmaturitiestheytakemoreinterestraterisk.Thekey
measureofabondorportfoliosinterestrateriskisduration.Durationisusedtoapproximate
thepercentagepricechangeinabondgivenachangeininterestrate:

Price=Ratesx(Duration)

Ifabondhasadurationof7andratesdecrease.50%,thechangeinpriceofthebondwillbe
approximately3.5%.Thatiswhatwecallsimplebondmath.Achallengeforportfolioa
managerisdeterminingwhatthedurationofaportfolioshouldbe,whentoextenddurationto
takemorerisk,andwhentoshortenduration.Wheninterestratesmove,theydonotalways
moveatthesamemagnitudeacrossthecurve.Giventhatthecurveiscurrentlysteep,we
wouldexpectratesinshortermaturitiestorisemorethanratesinthelongermaturities.
Returnsthisyearwilldrivenchieflybychangestothesteepness,orshape,oftheyieldcurve.
ThemarketswilleventuallystarttopriceinatighteningscenariobytheFederalReserve.When
thathappens,allfixedincomecurveswillflatten,andtheoptimalmaturitystructurewillbea
barbell.Abarbellstructuremeansthatbothshortandlongmaturitiesarefavoredatthe
expenseofintermediatematurities.Thekeychallengeinthecomingmonthswillbewhento
selltheintermediatepartofthecurveandbuildthebarbell.
Anadditionalcomponentofinterestrateriskisconvexitymanagement.Forthepurposeofthis
report,wewillusethepracticaldefinitionofconvexity.Convexityisameasureofhowsensitive
aportfoliosdurationistochangesinrates.Moreclearly,apositivelyconvexportfoliohasa
stabledurationwhenrateschange,whileanegativelyconvexportfoliohasavolatileduration
whenrateschange.Themunicipalmarketisbydefinitionanegativeconvexmarket,asmost
bondsareissuedwithatthemoneytenyearparcalls.Thechallengeforportfoliomanagersis
tostructurepositivelyconvexportfoliosandthenrebalancewhenrateschange.Giventhelevel
ofvolatilityinthepastfewmonths,itwillbeachallengetostaypositivelyconvex.Wevalue
positiveconvexitygreatly,andalwaysmakesurethatourportfoliosaremoreconvexthanthe
market.
TaxRisk
Themunicipalbondmarketisadistinctassetclassforonereasononly:theincometax
preference.Generallyspeaking,interestreceivedfromamunicipalbondisexemptfrom
taxationonthefederallevel,andtaxpreferencesexistatthestatelevelaswell.Whentax
ratesareexpectedtorise,thevalueofthesetaxpreferencesincreases.Likewise,fallingtax
rateshavetheoppositeeffect.Analystsareconstantlywatchingtaxpolicytoseeiftherewill
beanymaterialchangestothecodethatwillimpactdemand.LastyearsBuildAmericaBond
(BAB)programhadanimpactonthemarket.Whilenotachangetoataxrateortaxpreference,
theprogramchangedthewaythefederalgovernmentviewstheirsubsidytostateandlocal

governments.Inthesimplestterms,theincometaxpreferenceformunicipalbondsisan
indirectinterestcostsubsidyforstateandlocalgovernments.Becausethepreferenceexists,
municipalitieshavelowerborrowingcosts.Withoutit,themunicipalassetclasswouldsimply
beasectorofthecorporatebondmarket.TheBABprogramwasagamechanger.Thefederal
governmentdecidedtodirectlysubsidizeamunicipalitysinterestexpensebyhavingthemsell
taxablebondsandpay35%oftheinterestexpense.Therationalebeingthatbyincentingthem
tosellinthetaxablemarketplace,theywouldbeexposedtoalargergroupofbuyers,andthus
theiraftertaxinterestexpensewouldbelower.Theprogramwasconceivedinlate2008when
thecapitalmarketswerefrozen.Aninitialsellingpointfortheprogramwasthatitgave
municipalitysaccesstothecapitalmarketsthattheyotherwisewouldnothave.Theprogram
wasnotreauthorizedattheendof2010,butproposalsremainonthetabletoreviveitinsome
form,perhapswithareducedsubsidy.Thebottomlineontaxriskisthatthecodecanchange.
Evensmallchangestothecodecanhavematerialimpactonsupply,demandandvaluation.
LiquidityRisk
Allotherriskcharacteristicsaside,attheendoftheday,thepriceofanythingisdeterminedby
theforcesofsupplyanddemand.Thisistrueforoil,wheat,andalsobonds.Inthemunicipal
bondmarket,liquidityplaysahugeroleinvaluation.Liquidityisdefinedastheabilitytobuy
andsellbondsinanefficientandtimelymanner.Itisbasedonthepremisethatforeveryseller,
thereneedstobeabuyer.Whenthereisamismatch,themarketbecomesilliquidandprices
needtoadjusteitherhigherorlowerinorderfortransactionstooccur.Whentherearemore
buyersthansellers,bondpricesmovehigherandthemarketplaceisnotreallyallthat
concernedaseveryonesbondareappreciatinginvalue.Theproblemoccurswhenthereare
moresellersthanbuyers.Inthisinstance,bondpriceshavetofalltoenticemorebuyersinto
themarket.Sincethefallof2008,municipalmarketliquidityhasbeenanissue.Priortolate
2008,therewasadistinctgroupofplayerswhoensuredthemarketwasliquidonadailybasis
includingtheindividualinvestor,mutualfundinvestor,insurancecompany,arbitrageinvestor,
orWallStreetbrokerdealer.Whenoneofthesegroupstookabreak,itseemedanotherwas
theretotaketheirplace.Thebuyeroflastresortwasalwaysthebrokerdealercommunity.
Theywouldstepinandsupportthemarketifpricesfell.2008changedeverything.The
arbitrageinvestor,whofundedbillionsintenderoptionbondprograms,exitedthemarketen
masseaftertheauctionratemarketdriedup.Withnoabilitytosellsyntheticmoneymarket
instruments,therewasnoneedtobuylongbondsandderivativethem.Theirexitfromthe
marketcheapenedmunicipalbondsversusTreasuries.Whilethediminishedroleofthe
arbitrageinvestorhadamaterialimpactonliquidity,theprimaryhittoliquiditycamefromthe
brokerdealers.ThebankingcrisiskilledLehmanBrothersandBearStearns,twomajorplayers
inthemunicipalbondmarket,andforcedadditionalconsolidationinthedealercommunity.
WallStreetcapitalbecameapremiumasset.Bankscleaneduptheirbalancesheetsandmade
toughdecisionsaboutwheretocommitcapital.Theendresultwasthatthefewerfirmsthat
remainedinbusinesscommittedlesscapitaltotheirmunicipalbondtradingdesks.Intodays
market,whensellersoutnumberbuyers,WallStreetisnolongertheretosupportthemarket.

Wehaveseenhugeswingsinliquiditythepast24months.Theseswingsleadtomagnified
movesininterestrates.Understandingthatdecreasedliquidityisthenewnormal,wefindthat
therearetremendousbuyingopportunitieswhenliquiditydriesupandgreatselling
opportunitieswhenthemarketsfeelgood.Itisalwaysbettertobeabuyerwheneveryone
elseisselling.
Conclusions
Theargumentagainstmunicipalbondsseemstocenteraroundthefactthattherecessionleft
manymunicipalitieswithbudgetdeficits,andFederalaidtothestateswillbereduceddueto
theFederalgovernmentsownbudgetwoes.Thisbroadbrushanalysisignoresthefactthat
municipalitieshavemanytoolsattheirdisposaltoraiserevenue,andhaveflexibility,nomatter
howunpopular,toalsoaddressexpendituresinamaterialway.Further,thosetalkingabout
bankruptcyanddefaultseemtoforgetthatsuchamaneuverwouldpunishthemunicipality
intoperpetuitywithregardstotheirabilitytoaccessthecapitalmarkets.We,thereforethink
thatthemarkethaspricedintoomuchcreditrisk,andthatqualityspreadshavewidenedtoo
much.ThereisvalueinsingleAratedcredits,inbondsissuedbyfallenangelssuchasIllinois
andCalifornia,andinmostinvestmentgradecredits.Wewouldrecommendthatforthose
investorswithalongterminvestmenthorizonviewthisasatimetobuymunicipalcredit.
Regardinginterestraterisk,wefeelthatthegeneraltrendininterestratesistohigherrates,
giventheimprovingeconomyandincreasedinflationexpectations.However,asrateshave
risenrapidlyoverthepastfewmonths,wewouldviewafurtherselloffasashorttermbuying
opportunityforlongdurationassets.Onalongtermbasis,wearerecommendinganeutralto
shortdurationpositionandabarbelledmaturitystructure.Regardingtaxrisk,wefeelthatthe
generaltrendistowardshighrates,especiallyonthestatelevel,andthisfavorsmunicipal
bonds.Finally,liquiditywillcontinuetobeachallengeaslongasthebrokerdealercommunity
standsonthesidelines.Wethinkthisisthenewnormal,andwouldviewperiodsofilliquidityas
buyingopportunities.Thosewithalongterminvestmenthorizon,asolidbaseinfundamental
creditanalysis,andthecouragetogoagainstpopularopinionwillberewardedonrelativebasis
versusTreasuriesandcorporatebonds.Wewilllookbackonthefirstquarterof2011asagreat
buyingopportunityformunicipalbonds.Remember,twoyearsagothisMarch,therewere
recordoutflowsfromequitymutualfunds.AnyonewhosoldinMarchof2009andhidinthe
bunkermisseda100%rallyintheS&P500.
Sources:
1.
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