Fund Managers Are Playing the Wrong Game With Munis
Bond fund managers who are optimistic about the muni market tend to offer up statistics that seem to show the relative health—at least in the short term—of city and state governments.
Unfortunately, the relevance of these numbers depends on assumption about the behavior of states and cities that is unwarranted.
Here’s what the assumption is: muni issuers will tend to behave like corporate borrowers.
We already know this is wrong. As the following chart from Wells Fargo shows, munis have historically defaulted at a much lower level than corporates.
This is usually taken as a sign of strength for muni debt. But that’s not a conclusion supported by the evidence. What is supported is the idea that muni debt behaves differently from corporate debt—and that the circumstances for muni debt defaults have not arisen in the past.
In many ways, corporate credits are safer than munis. Or, at least, they are subject to very different risks. Corporates are subject to economic risk, in the first place, and business plan risks in the second place. Munis are subject to political risk, which is a very different thing.
Corporations almost never voluntarily default. Lenders can almost always be assured that if debt servicing levels are not crippling and revenues are strong, corporate credits won’t default. Even when money becomes tight, corporations will cut dividends, stop expensive operations, and downsize their headcounts to avoid defaulting. Shareholder and creditor interests are usually aligned when it comes to defaults on loans, since shareholders are usually wiped out in a bankruptcy.
The optimists tell themselves that debt payments on munis are “still far from becoming an unsustainable burden.” But states and city defaults need not be mandatory defaults—triggered by a complete inability to pay taxes. Unlike corporate credits, muni credits can go into default voluntarily or, even, accidentally.
States and cities don’t have workers, shareholders and creditors. They have workers, voters and creditors. Governments are far more answerable to workers and shareholders than corporations are—which means they are far more likely to default than corporations are.
(As an aside: advocates of “shareholder democracy” might want to consider this more closely. Making corporate management more answerable to worker controlled pension fund shareholders will likely increase the default risk.)
Think about it this way. The muni bond optimists claim that typically issuers will implement a combination of aggressive spending cuts and tax hikes if they encounter financial distress. But this is unrealistic. It’s far more likely, in the current political environment, that many governments will find themselves between the Tea Party Scylla resisting tax-hikes and the public worker Charybdis resisting spending cuts. It should be at least acknowledged that there is a strong possibility that bond holders will not emerge unscathed between these forces.
Corporations almost never chose to lower their revenues, especially if doing so would interfere with debt payments. State and local government frequently cut taxes and lower revenues. The projected revenue stream of state and local governments is not just a function of the market—it is subject to strong political decisions.
The equity of shareholders is often wiped out when a corporation goes into bankruptcy. Nothing that belongs to citizens is wiped out when their city or state defaults on debt. This means that citizens do not have the same comity of interests with bondholders. They can choose to default without suffering a direct penalty.
One of the top traders at Nassim Taleb’s fund once told a story about a lecture given by a former executive of Long-Term Capital Management.
Here’s how author Malcolm Gladwell tells the story:
“What he said was, Look, when I drive home every night in the fall I see all these leaves scattered around the base of the trees,?” Spitznagel recounts. “There is a statistical distribution that governs the way they fall, and I can be pretty accurate in figuring out what that distribution is going to be. But one day I came home and the leaves were in little piles. Does that falsify my theory that there are statistical rules governing how leaves fall? No. It was a man-made event.”
In other words, the statistical likelihood of events can be interrupted by human action and choice. The people that matter for muni bond defaults—voters, politicians, public workers—are fallible, have different perspectives and interests than bond fund managers or investors, they may hold different and conflicting values, their own goals and values may not even be self-consistent,
In short, muni bonds suffer from political uncertainty that makes most of the analysis that goes into the optimistic case for munis simply inapplicable.
Bond managers are playing finance in a stadium where everyone else is playing politics. Their analysis of the “risks” of default tend to be based on a naïve view of politics—one that is essentially just financial economics. As my brother Brian Carney said today on twitter, “Bill gross is playing poker in the muni market, but thinks he's playing bridge.”
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