The municipal bond market exhaled last week when the Federal Reserve announced that it was not planning to start scaling back its open-ended bond buying program anytime soon. State and local governments had been on edge after suggestions in June that led many to expect an imminent about-face on monetary policy sure to bring to an end what has been the greatest run municipal bonds have experienced in decades (Chart).
But no taper; the Fed once again postponed munis' day of reckoning. We must therefore wait longer to learn what the new normal is for the municipal bond market, and what resemblance it bears to the old normal, which lasted from the Great Depression to the Great Recession. For most market observers and participants, that period defines how the market is supposed to work.
It's been an eventful half decade for the famously sleepy muni market: several high profile bankruptcies and defaults, the collapse of the municipal bond insurance industry, and heightened awareness of the threat that governments' retirement benefit obligations pose to their fiscal stability.
But whatever negative effect any these developments has had (none could be thought to have had a positive effect), it has been easily overwhelmed by quantitative easing.
This month, two bond rating agencies released reports that took a bearish position, predicting tougher sledding ahead for municipal bonds.
Investing in municipal bonds could become a riskier proposition in two ways: bonds could default more often and/or recovery rates, when defaults do occur, could be lower.
In its report, Moody's raises concerns about the low rates of recovery experienced by holders of defaulted debt from Jefferson County, Stockton, Vallejo and Detroit. According to Moody's, in the future, if you buy a municipal bond, you'll may be about as likely to get paid back in full as in the past, but if you aren't, you should expect to get paid back even less than before.
To Moody's, more important than the total number of defaults is what kind and for what reason did they occur. The future will bring more defaults driven by "service level insolvencies," in which "the bond issuer [does not have] the money on hand to carry out basic governmental functions." Old-normal defaults were generally caused by a liquidity crisis, after which bondholders were generally made whole, if not on the schedule they were expecting. By contrast,
Defaults resulting from service level insolvency are increasing and will likely lead to larger losses to bondholders than those caused by temporary liquidity constraints. Unlike defaults in other municipal sectors, such as not-for-profit hospitals or housing project financings, local governments must continue to operate through fiscal distress and maintain an acceptable level of government service. In a service level insolvency scenario, a government may seek to adjust revenues and spending, but ultimately is likely to need to reduce liabilities and annual outflows in order to allocate scarce resources to essential services. In this scenario the government will opt to preserve a basic level of services to protect the health and safety of its residents rather than pay debt service. Indeed, claims of "service level insolvency," or the risk a government may not be able to provide essential public services, may be used as a rationale for both filing for bankruptcy or failing to honor debt obligations.
It all comes down to the will to pay, which Moody's believes has been weakened as governments' will to stiff creditors has been strengthened by the actions of Jefferson County, Stockton and Detroit. "The 'stigma' of bankruptcy and default in the municipal market may be changing."
Standards are falling all over, as governments seem to be getting away with behavior previously assumed to prompt the wrath of bond vigilantes. Fresh of their defaults, Jefferson County, Harrisburg and Detroit are already laying out plans to reenter credit markets. If traditional lenders balk, Moody's strongly suspects that hedge funds and other "nontraditional" muni market players will pick up enough of the slack to ensure that, "issuers retain market access at a tolerable cost of capital," leading to "greatly diminished""disincentives to bankruptcy and/or default."
Kroll Bond Ratings writes in another new report that it also believes we're going to see "substantially lower recoveries" from muni defaults, but its analysis focuses more on the default rate itself. Kroll foresees a future default rate more in line with that of the 2008-12 period (.29% of total par outstanding-.77% in 2011) than the 1980-2012 period overall (.18%). Muni analysts should rely less on historic market experience, according to Kroll, and adopt "more due diligence and a forward looking view."
There's no indication we're going to see a "systemic wave" [sic] similar to that which occurred during the Great Depression. Kroll believes "enhanced oversight" by both state governments and the investment community will prevent that from happening.
But, like Moody's, Kroll believes that defaults will be more common because of envelope-pushing on the part of Stockton et al. We're going to see a more chaotic market, and perhaps not one that leads to greater fiscal discipline on the part of state and local governments.
It seems like the debate really might have shifted here. Instead of writing off Central Falls and Stockton as totally anomalous, establishment voices now view them as telling, representative.
But we won't know right they are until two things happen: quantitative easing ends, and governments go through another recession. Assuming the next recession will be of a level of severity closer to that of the early 90s or dotcom recessions, not the last one, how bad will it be for municipal bonds? Mild recessions have traditionally not caused credit crises for state and local governments. But Moody's and Kroll seem to suggest that next time will be different.
