Black Swans and Muni Bonds

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Munis rallied last week, after four weeks of falling prices and rising yields, according to The Bond Buyer newspaper. Similarly, outflows in muni bonds have slowed in recent weeks—prompting some to say that the market is starting to recover. Muni defaults were actually lower in the first quarter of 2011 than they were during the beginning of 2010.

Many muni bond professionals believe that fears of a massive wave of defaults are “overblown”—and they look at recent signs of strength as an affirmation of their view.

Unfortunately, many of those who insist on the strength of the muni market seem to be blind to the vulnerabilities of muni bonds.

Many muni bulls insist that they can accurately predict the level of muni defaults and the types of munis most at risk. They taunt skeptics like Meredith Whitney for failing to produce specific predictions about exactly how many munis will default, which issuers will most likely default, what will trigger a wave of defaults, or when they will happen.

Although they never actually admit this, the muni bulls are insisting that municipal debt is exposed only to normal, predictable risks—and not unpredictable, wild risks. To put it in the terms of Nassim Taleb, they are claiming that all muni market swans are white—because they’ve only encountered white swans in that market before.

This is why they are comfortable making forecasts based on past performance. It’s why they can claim to know that some kind of muni bond—say, a general obligation bond or an essential services revenue bond—is likely to outperform another kind—a revenue bond tied to a specific, non-essential project—in the event of a crisis.

What they are ignoring is that we lack the experience or tools that would enable us to produce computational models of muni defaults.

And—more importantly—they are ignoring the fact that munis are exposed to fragilities that could lead to wild randomness—and losses beyond all historical experience. The muni market is subject to “black swans.”

What are the vulnerabilities of the muni market?

1. Politics.Muni bonds are subject to political risk—which is essentially random and unpredictable. Even if defaulting on debt is an incredibly stupid thing for a municipality to do, there is no guarantee that politics will lead to wise decisions.

2. Uniqueness.Munis exhibit very different behavior from corporate debt. This means that systems built on corporate debt models—such as those employed by ratings agencies to estimate credit risk—may be extremely ill-fitting.

3. The Shunning Assumption. The notion that a muni default would result in an issuer being shut out of the marketis only hypothetical and is highly contestable. There is reason to believe that widespread defaults could greatly reduce any market penalties for individual issuers from defaulting. Politicians are aware—or will become aware—of these reasons, which affects their decisions of whether to pay muni bondholders in full.

4. Reflexivity.Isolated defaults can trigger broad market sell-offsfor emotional and technical reasons. The sudden appearance of risk can frighten investors out of the market, and can force those subject to strict risk management to reduce exposure. This selling makes the market appear even riskier, prompting more selling. A downward spiral can ensue.

5. Information Cost is High. Muni 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—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs.

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysisor a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

7. The Pretense of Expertise. The fact that so many bond gurus and muni bond professionals believe they can accurately forecast in the market—and ignore the six sources of fragility above—creates its own risks. It means that they may be caught off-guard and unprepared by losses more severe than predicted. To the extent that the pretense of expertise is a source of muni strength—the shattering of this pretense may result in a muni panic.

I’m not sure the bullish bond gurus are even aware of these fragilities. Nothing they have said in the last few months reveals that they’ve given this danger any though whatsoever. This in itself is a reason for investors to be cautious.

I can hear some readers already asking: “So, Carney, will the muni market see a massive wave of defaults?”

That’s the wrong question to ask.

The point here is not that we should try to better forecast the performance of muni bonds—or adjust our forecasts with a bearish bias.

It’s that investors need to be aware that the performance of muni bonds is subject to unpredictable risks that can make accurate forecasting impossible.


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