Dwight Cass
06/01/2005
Like a school of sardines executing a perfect 180-degree turn when startled by a barracuda, investors often overreact en masse to bad news. When General Motors admitted in March that it is not very good at making money in the car business, the entire $5 trillion corporate bond market—of which GM accounts for about $300 billion-shuddered.
Investors realized they had portfolios stuffed with (de facto, if not yet de jure) GM junk bonds—a rude awakening for those who had not actually followed prices in the market, where GM has traded at junk levels for some time.
For many investors, the bond market, coming off a two-decade-plus rally, suddenly took on a treacherous cast. Investors came to understand that they had underpriced risk in broad swaths of the market, and that they had relied too much on the ratings agencies (all three of which maintained GM at investment grade at press time).
For a week or two, panicked sellers drove prices downward. While the market subsequently stabilized, its long-term prospects are not too cheerful. With hints of inflation pressuring the Fed to accelerate its policy of slow-but-steady interest rate increases, the credit markets may be in for a long, rough slide downward.
Closer to Home
While GM’s drama made headlines for weeks, a problem of
similar scale in the murky world of municipal finance could also have widespread
effects, but go unnoticed by all but market professionals. Indeed, similar macro
problems afflict the multitrillion-dollar market for municipal bonds—considered
the ultimate sleep-well investment for taxable investors. Most of these
securities, issued by cities, transit systems, school districts and other public
entities, secure high investment-grade ratings (either the municipalities are
creditworthy, or they wrap their bonds in insurance against default).
But
municipal finance is now a bit more complex than the last time the Fed yanked
its leash to bring the economy to heel, in the late 1990s. Many municipalities
have sought to plug their yawning budgetary gaps with money earned by selling
derivatives. Market observers say that, as a group, U.S. municipalities have
sold derivatives on more than $500 billion of bonds.
As any muni investor
knows, a typical 30-year municipal bond is callable after five or 10 years; this
call option allows the municipality to refinance if interest rates fall. In the
low interest rate environment of the past several years, these call options have
become extremely valuable, and thus many municipal treasurers have sold them to
banks in derivatives-based transactions. This strategy has reaped many tens of
millions of dollars for municipalities with multibillion-dollar bond portfolios.
The downside to these deals is that they leave a municipality unable to
refinance its bonds—it is stuck paying higher coupons for the entire life of the
security. The municipality takes all the savings it otherwise could have reaped
over time as a (smaller) lump sum up front. If the city or agency needs to issue
additional debt in a rising interest rate environment to plug its budget gaps,
the additional costs may force it to cut back on the services it provides. For
municipalities with particularly shaky finances, it could also lead to
insolvency.
The insurance wrappers municipalities use to ensure high ratings
make many investors upbeat about their prospects. They believe they are betting
on the credit of the insurance company, not the municipality. But should a large
and uninsured deal run into trouble, or a host of insured deals pressure one
insurance wrap provider, it could precipitate a GM-style rush for the door that
would hurt everyone—investors, municipalities and taxpayers alike.