While muni bond optimists come in a variety of flavors, they all miss one important factor: the risk of municipal debt contagion.
Reading through the various publications put out by banks and bond fund managers, you frequently come across two strategies.
Wells Fargo, for example, advises clients to have a diversified portfolio so that isolated defaults won’t have a large impact on the overall returns.
Pimco, on the other hand, tells clients that the key to success in muni investing is picking the highest quality muni credits.
Both of these strategies will fail, however, if muni debt defaults go viral.
Both the performance of a pick-the-winners Pimco-style strategy and the performance of a Wells Fargo diversification strategy are critically dependent on the linkage or correlation of defaults in the bonds. If muni bond defaults are independent events, either strategy can work. But if defaults are linked or correlated—that is, if defaults tend to spread—then both strategies can fail.
In theory, municipal debt defaults should be isolated and unlikely events. There’s no financial reason why a default by, say, Illinois should make a default by Ohio more likely. The decisions that would lead up to a default are made by different political bodies, the spending and revenue challenges are relatively independent, and the debt costs vary from state to state, city to city. There is no technical or fundamental reason why a default somewhere should trigger domino defaults or even a mass sell-off of muni bonds.
Unfortunately, this view is short-sited. There are real contagion risks in the muni space. Some are what we might regard as technical—where losses on a muni portfolio trigger a contraction of credit, triggering further sell-offs, more losses, more sell-offs, and so one. Others are not technical—they don’t have to happen—but they are no so unlikely that they should be ignored.
We already know that the assumption that muni credits trade independently of each other is wrong. When market participants became concerned with risk in the muni space, muni’s sold off. Outflows reached $3.1 billion over the week of November 15, the largest outflow on record. In December, following a warning from Meredith Whitney, we saw more investors withdrawing from the space. These outflows from these funds triggered significant sell offs by muni funds. In short, muni performance is correlated.
The source of this correlation is reflexivity. The perception of risk feeds on itself. As investors in bond funds become wary of risk, they withdraw money from the funds. The funds are then forced to sell off bonds to cover the withdrawals, which in turn raises the yields on the underlying bonds—making them appear to be even riskier.
This triggers a new rounds of selling—for both emotional and technical reasons. Individual investors in bond funds keep withdrawing money as the apparent risk increases—after all, these investors typically have invested in munis as a balance to the riskier parts of their portfolio. As apparent risk in the muni market grows, they re-balance out of munis.
For certain types of institutional investors—those that are subject to strict capital requirements and internal risk-management controls—the rising yields can also trigger a sell-off. These are not emotional investors. Rather, as the mark-to-market values of their muni portfolios fall and the market starts sending off signals of risk, they need to retreat to safer assets. Levered investors—including hedge funds—may start to receive margin calls, forcing them to shed assets.
Absent a large or significant default, this process will likely remained contained—perhaps counter-balanced by others in the market who see opportunities to by the shunned muni bonds at a discount. But once a significant default occurs, the situation changes dramatically.
A large and significant default would reveal the unpredictability of the market. Since no reliable metric would have indicated the default in advance, market participants will be forced to realize that they cannot predict future defaults. Just as banks refused to lend to each other during the financial crisis of 2008 because they could not tell which other banks might be insolvent, investors may shun all munis because they cannot tell which are likely to default. The one default will have revealed the lack of information and fragility of the market.
Informational costs—to borrow a term from the economists—are sky high in muni debt. Issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection on munis—is thin and unreliable. The bond insurers are mostly out of business.
The high cost of information when combined with the revealed lack of forecasting ability following a default, has the potential to trigger a broad and indiscriminate sell-off of muni bonds. The contraction of credit would raise borrowing costs for new issues, potentially causing further defaults from munis that need to roll over debt.
This, far, however, what we have is not a recipe for a “wave of defaults.” It is a recipe for a contagion that causes mark-to-market losses on bond portfolios and a marginal increase in defaults. That will be hard to take for some investors but not necessarily cause outsized, permanent losses for long-term investors who avoid the panic.
The more serious form of contagion is one in which one default triggers other defaults. One way this can happen is that defaults—or potential defaults—by cities or important agencies can put pressure on state budgets. The cost of bailing out the city or paying for services now that the city no longer has credit market access could put a state in financial distress. Other cities may resist tax-hikes to pay for the defaulter or, more dangerously, default themselves in order to receive the aide. Eventually, this can trigger a default at the state level.
Another way for defaults to go viral is for the political acceptability of defaulting to change. If some cities or states default, putting losses on bond-holders rather than inflicting higher taxes on taxpayers or cuts on public workers, the stigma for defaulting could evaporate. More seriously, the stigma could go the other way. If Chris Christie announces that New Jersey won’t pay off its creditors at 100 cents on the dollar, would Andrew Cuomo be able to resist the temptation to follow suit? Would you want to be the politician who is “in the pocket of the bond holders?”
In few scenarios is it likely that bond holders would be completely left out. Far more realistically, they would be forced to accept terms that are more generous to the issuers. Lower interest rates, principal reductions, longer terms.
Whether or not these contagion scenarios occur remains to be seen. But the contagion risk is real. And, unfortunately, it is being ignored.
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