The Evolution of the Municipal Credit Market

She had the right idea, but missed on scope and timing. “There’s not a doubt in my mind that you will see a spate of municipal bond defaults. You could see 50 sizable defaults, 50 to 100 significant municipal bond defaults in 2011.This will amount to hundreds of billions of dollars worth of defaults.” –Meredith Whitney’s Muni Meltdown Prediction; aired on CBS 60 Minutes, 12/19/2010

Evolving from a rates market to a credit market. While those dire predictions failed to materialize, escalating unfunded pension liabilities did result in growing budgetary strain and idiosyncratic[1] risk. The $3.7 trillion municipal credit market has over 50,000 unique issuers. The financial needs of state and local governments together with other public benefit entities have led to a highly fragmented and diverse market. Each sector has nuances and characteristics that we believe require different tools and metrics to determine credit strength and investment potential. Opportunities exist within individual sectors, and credit analysis is essential to determine value.

We believe the municipal credit market is undergoing a significant evolution from what was a high quality and low volatility “rate-like” market to an idiosyncratic intensive credit market. This means that fundamental and thematic municipal research will be much more meaningful in the pursuit of investment opportunities.

Insurance penetration has plummeted since the financial crisis

Insured issuance (in billions)

Source: Bond Buyer

The Catalysts.  Two related factors are behind the evolution of the municipal credit market; the withdrawal of insurance coverage and the decline in credit quality. As the first graph shows, the municipal landscape has changed dramatically since 2008 when the largest monoline bond insurers (MBIA, Ambac, FGIC) lost their AAA ratings, largely the result of exposure to collateralized debt obligations. Prior to that time, more than half of the new issues were insured with the broad market primarily looking to the credit quality of the insurer. As illustrated in the graph below, today less than 10% of new issuance is guaranteed by a monoline insurance company. Furthermore, the market historically traded on Rating Agency ratings which were not always accurate or up-to-date. It is not uncommon to have stale ratings based on outdated financials.  Capturing financial, demographic, or policy trends can be critical in eliminating potential credit surprises.

The case for an independent and disciplined credit process. Beyond the market adjusting to the need to underwrite the actual credit instead of relying on the insured rating, the overall credit quality of the market has been declining. For example, unfunded pension liabilities continue to grow; states have less in reserves than they did prior to the Great Recession, despite eight years of economic growth since; and anti-tax sentiment is high thereby reducing financial flexibility. As the following graph shows, the number of Chapter 9 municipal bankruptcy filings, while still a rare occurrence, have almost doubled during the past seven years. Therefore, security selection has become vital to portfolio performance. Recent bankruptcies in Jefferson County, AL and Detroit, MI, along with Puerto Rico’s default and its ongoing financial crisis, have had a significant impact on investors and how we view credit fundamentals.

Default volume is driven by large general governments and utilities

Default amount by sector per calendar year (billion USD) 

Source: Moody’s Investor Service

While our fixed income credit process has always been driven by the credit fundamentals of the issuer, we think these recent events underscore the value and importance of having an independent and disciplined credit process.  Metrics regarding operating performance, leverage, and liquidity are essential in determining the financial health of an entity. However, these quantitative metrics paint an incomplete picture when determining the stability of an investment. Considerations such as fiscal management, political competence, regional economic health, and sector trends, in our view, must be included in a thorough analysis. Illinois, Connecticut, New Jersey and Pennsylvania are examples where qualitative analysis is a significant consideration. From a credit perspective, it is imperative to monitor the political willingness and any actions taken by the legislature and governor to address budgetary issues, pension funding and debt. A simple review of quantitative metrics provides an incomplete credit picture – demonstrating the critical nature of a comprehensive credit review. 

Uncovering relative value. A deep understanding of a bond’s legal provisions, including the different structures, liens, and covenants[2], can allow investors in long term, stable credits to uncover relative value while avoiding potential credit traps. A well-known issuer, the Pennsylvania Turnpike, provides a clear example. As a large toll road system, with a well-established market position and stable demand, Pennsylvania Turnpike bonds can have varying degrees of credit quality. The first lien bonds[3] are secured by a first lien of net revenues of the turnpike; these bonds are secured by a debt service reserve fund and have legal provisions in place to help support the credit. The subordinate lien bonds have significantly weaker legal covenants; subordinate bonds are secured only by payments from the general fund of the turnpike, with no lien on toll revenues. While both structures are issued by the same issuer, the two are inherently different with unique risks applicable to each – a similar name does not necessarily mean a similar credit. A comprehensive analysis of the legal covenants and provisions; combined with conducting frequent investment strategy, thematic and sector discussions; and leveraging technology and artificial intelligence platforms are important steps in uncovering relative value.

This is not your parent’s muni market: Credit research matters

The municipal bond asset class has evolved to a credit-driven market. Whereby, bond insurance is no longer prevalent, disclosure is inconsistent, and ratings alone are not sufficient to determine the creditworthiness of an investment relative to historical conditions. A credit process consisting of both top-down and bottom-up, idiosyncratic research, covering macroeconomic fundamentals, individual issuer, and legal framework evaluations can be quite additive to managing portfolio risk, and finding alpha within the municipal market.