The timing of the Fed's taper decision and the horror show over the country's debt ceiling are captivating the markets, but evolving municipal fundamentals are a bigger story for muni investors. The situation in Detroit reveals a number of key elements that are also significant throughout the municipal market--including the role of bond insurance and use of derivatives, as well as pension and retirement liabilities. In the aftermath of Detroit, market participants have cast a critical eye on other stressed municipalities--especially Puerto Rico, whose debt is widely held and, if impaired, could have a wide-ranging impact.
Focus on All Things Federal
Since our last outlook, much has transpired to roil fixed-income markets in general and the municipal market in particular. While the "official" end of the Federal Reserve's extraordinary efforts at providing liquidity has not been announced as we write this, the market has continued to take matters into its own hands, with 10-year U.S. Treasury yields approaching 3.00% from lows in the 1.40% range a little more than a year ago. Yes, that is a doubling of the rate in a 14-month period. Clearly the market has chosen to act pre-emptively regardless of the Fed's official stance. As is always the case with markets, perception is reality, and bond market participants perceived long ago that rates were artificially low.
In Washington, D.C., the horror show around raising the federal government's debt limit is playing out once again. The real danger with this exercise is that the brinkmanship being evidenced goes too far, and the government of the United States is not able to pay its debt obligations on a timely basis. That is always the danger with games of brinkmanship--they go too far, and by then it is too late. The consequences of a default are far beyond our purview to analyze in detail, but needless to say, they would be disastrous. Yet the fact that this possibility is even being discussed speaks volumes about the current state of dysfunction in Washington. Consider that this result would mean that the world's largest, richest economic power defaulted not because it could not pay its creditors, but rather that it chose not to do so.
Taken together, there is much for bond investors to focus on transpiring in our nation's capital. Yet, for municipal bond investors there remains a bigger story and that is the continuing evolution of credit, post-financial crisis.
The Times They Are A-Changin'?
One of the hallmarks of the municipal bond market has been the remarkable safety of the asset class since the Great Depression ended. In that period of time munis have had a much safer record of return of principal than corporate bonds, second only to U.S. Treasuries in default safety. That safety has been taken as an article of faith by investors. The question facing the market today is whether that faith is warranted.
Last summer the sad story of Detroit took an ominous turn, with the city filing for bankruptcy protection in federal court on July 18. The filing is the largest municipal bankruptcy filing in history with the city estimating its total liabilities to creditors of all types at approximately $19 billion. As we write, the court is reviewing the filing to decide if the case will be accepted. While there have been a number of relatively high-profile municipal bankruptcy filings over the last few years, Detroit is in a class by itself.
Municipal bankruptcy is allowed via Chapter 9 of the federal bankruptcy code. Therefore, bankruptcies are adjudged in federal court. No state can declare bankruptcy, only local governmental units, and only if specifically allowed by state law. Currently, 34 states allow Chapter 9 filing, with a wide variety of provisions around how that can be done. In these states a municipality has to file for bankruptcy, the court reviews the filing and decides if the applicable state laws have been followed before accepting the case, which is where Detroit stands currently.
It is important to note that bankruptcy, though by definition a means to provide shelter from creditors, does not equate to a default on debt. In the case of Vallejo, Calif., the city declared bankruptcy but never missed a payment on debt service before exiting bankruptcy. To date, Detroit has chosen to not make interest payments on pension obligation certificates due on June 15 but did make interest payments on bonded debt due July 1. The next debt payments due on Sept. 30 are from a 2003 Convention Center bond issue, which is secured by state liquor tax receipts. After that are payments due Oct. 1 for general obligation issues. Both of these dates come before the expected ruling on whether the bankruptcy filing will be accepted by the court.
A Microcosm of Municipal Bond Market Credit Influencers
Examining the situation in Detroit reveals a number of key elements that are also significant throughout the municipal market. Leading up to the financial crisis two types of financing tools had become widespread. The first was the issuance of bond insurance to provide a credit enhancement for investors. The second was the use of derivatives by issuers to "manage" interest rate risk, primarily through the use of a type of transaction known as a "swap." Both are key factors with Detroit. Another topic of keen interest to the market has been pension and other retirement benefit liabilities. For Detroit retirement benefits are an additional element of critical importance.
As has been documented in many places the prevalence of bond insurance had covered over half of new issuance by 2007. The ratings on these issues were almost universally the highest available, giving the impression that the municipal market was homogeneously strong. Post crisis these insurers have experienced a rocky road with falling ratings and a precipitous decline in underwriting to less than 10% of annual issuance. For many market observers, the topic of insurance was viewed as a relic of sorts with little meaning for investors. That idea has been proven short sighted in light of Detroit's filing. Over 85% of debt outstanding is covered by bond insurers. For investors the ability of these insurers to make payments will be critically important to how the bankruptcy filing affects them. For the insurers the significant exposure will have a major impact on their financial strength. In that regard, the situation in Detroit has implications for any bond investor holding insured debt from one of these insurers.
Interest rate swaps are a type of financial transaction whereby two parties agree to exchange interest rate based payment streams. In the case of Detroit, the city entered into agreements with two major banks, Bank of America (BAC) and UBS (UBS), which are outstanding. Like its other liabilities these swaps are subject to review by the court. Specifically, the court will have to decide whether the city can allocate revenues to the swap transaction while sheltering the revenues from other creditors or not.
Pension funding is perhaps the most controversial topic in municipal credit today. The public sector remains the last bastion of defined benefit retirement programs, as the private sector long ago shifted to defined contribution plans. The accounting for pensions is complex and arcane to begin with, but in the case of Detroit it has become a murky situation indeed. At the heart of the issue is the simple need to estimate the size of the pension liability itself. There is a wide difference of opinion between the city and its creditors on what that amount should be, which of course influences the overall settlement of outstanding liabilities. How this is decided may provide important precedence. Perhaps as important is whether the federal court can supersede state constitutional law, which protects these pension benefits.
Municipal credit quality can be a complex thing to analyze, and Detroit, while seemingly simple on the surface, impacts key aspects of the municipal market with potentially wide ranging implications.
Not the Problem in the Market?
The problems leading to Detroit's bankruptcy filing were well-known. Ratings agencies had downgraded the city's debt to below investment grade, and investors were demanding relatively punitive yields. Yet the actual filing did impact the market. Bonds are trading at significantly cheaper levels. The different security pledges for the various issues outstanding are being analyzed with greater scrutiny. Assessing the state of the bond insurers backing these issues is a critical element in determining investor outcomes. In the aftermath, market participants have cast a critical eye on other municipalities that are considered stressed. Increasingly that focus has fallen on the Commonwealth of Puerto Rico.
Like Detroit, the territory has had a difficult time economically and is fiscally stressed. Unemployment is high, gross production has contracted and this has negatively impacted the island's finances. Pension liabilities are daunting and extremely underfunded regardless of the assumptions employed. Currently most bond issues are rated investment grade but with no room for further downgrade before losing that status. The market has begun to react with yields rising significantly, aided by headline risk due to a number of incriminating articles. In short, Puerto Rico appears to be in a very tight spot with access to capital markets being limited and the price of capital becoming dear.
The potential impact of Puerto Rico on the municipal market is difficult to overstate. Unlike the bonds of Detroit, which were held by relatively few investors, Puerto Rico debt is widely held due to its "double-tax free" benefit. Many individuals in states with high income tax rates hold bonds either as individual holdings or in bond funds. The amount of debt outstanding is multiple times greater than Detroit. As a territory, Puerto Rico cannot avail itself of Chapter 9. Without engaging in speculation, it is safe to say that all muni market participants have a vested interest in a positive outcome for the commonwealth, given its current difficult challenges. Morningstar views this as perhaps the single most important event in the market since the near meltdown of New York City in 1976.
The Municipal World Has Changed
Prior to the financial crisis, it is safe to say that the prospect of a bankruptcy by Detroit or the critical state that Puerto Rico currently faces would have been virtually unthinkable. There was a history of safety, there was a robust insurance market, the economy was strong, prior problems had been faced down or recovered from with relatively little lasting pain. As this quarter unfolds, we are likely to see developments with both Detroit and Puerto Rico that will have lasting and widespread impacts. More than any time since the Depression the municipal market has become a credit market. Meredith Whitney may have grossly exaggerated the danger, but there is no denying that credit is the key as we close out 2013.
Jeff Westergaard does not own shares in any of the securities mentioned above
- Puerto Rico