By Yali N’Diaye
WASHINGTON (MNI) – Although flows to municipal bond funds have been
slowing, many believe the default risk remains low in the muni space,
and states and local governments have been taking measures to address
their budget and long-term liability issues.
Still, the sector is not out of the woods yet, with rising defaults
on general obligation bonds looming.
That being said, massive GO bond defaults are generally not
expected.
“I think there are going to be some more general obligation bond
defaults in the municipal market,” said Mitchell Savader, CEO at Savader
Asset Advisors.
“While economic conditions are getting better, they are not getting
better fast enough to offset some of the growing problems,” said
Mitchell, who advises institutional investors.
For the 26 years he’s been in the muni market, he added, “there are
problems now that I have never seen before systematically across the
entire market.”
He cited the “growing severity” of the problems related to pension
funding as well as other-than-pension employee benefits for states and
local governments that have been “overly generous.”
To be sure, efforts, notably by states, are being made to address
the issues.
Rating agencies are indeed seeing intensifying efforts by U.S.
states to rein in their long-term liabilities through pension reforms,
which no doubt is a positive in the states’ credit assessments.
That being said, pressures from other areas are mitigating this
positive element, suggesting little if any upward rating adjustments in
the near term based on pension reforms.
That is not only because costs related to Medicaid are piling up
but also because pension reforms are mostly geared towards future
employees, suggesting gradual improvements in pension funding are
unlikely to affect ratings in the short term.
It does not mean that huge amount of issuers will default or that
defaults will represent a “huge” share of the $2.7 trillion muni market,
Mitchell told MNI.
The increase in GO bond defaults will be “nowhere near what was
being called for even a year or two ago,” he predicted.
So overall he is “cautiously optimistic” for the muni market.
Mitchell expects defaults to be more on the high yield side,
although “it’s possible these stories have not been learned about yet.”
Municipal Market Advisors Analyst Matt Fabian told MNI that “only
325 issuers (out of an estimated 50,000) are in payment default,” which
is about 0.01% of the outstanding bonds.
“It’s reasonable to expect there will be more local governments
either defaulting or looking for concessions from bondholders,” he
conceded.
“Local governments are still feeling credit pressure (because of
states cutting aid as much as their own tax revenue problems), which is
probably increasing across the country,” he said.
However, he estimates “only 0.06% of the GO traditional sector is
either in payment default, drawing on reserves or using bond insurance.
So even a large uptick in default incidence will mean the absolute
default rate will still be extremely low.”
He added “The vast majority of these defaults have come in
non-rated, high-yield type sectors, where bonds are, for the most part,
purchased by high-yield funds or very wealthy individuals who understand
the risks they are taking.” He stressed “This is not traditional
municipal bond investing as it’s portrayed in the media.”
Certainly, defaults have historically happened in the high-yield
muni space, said Triet Nguyen, a Managing Partner at Axios Advisors LLC,
a Chicago-based municipal credit research boutique.
But, “That will be a big change going forward,” he told MNI.
Nguyen expects “more — at least an increasing share — of the
defaults to come from the more traditional muni sectors” such as general
obligation bonds and essential services.
“More local governments and local agencies are going to get into
trouble this year and next year,” he anticipates, citing the lagging
effects of lower property taxes and other economic impacts of the
housing downfall.
What’s more, as part of states’ efforts to balance their budgets,
they have kicked down problems to local governments by cutting state
financial aid.
So “The states are looking a little better now but it’s happened at
the expense of local governments,” Nguyen said.
Illustrating this point, Moody’s commented in its Credit Weekly
Outlook Monday that with Michigan to withhold aid to Pontiac schools,
the school district will experience “a severe credit challenge.”
“Pontiac School District’s lack of a detailed budget plan led the
state to withhold funding, which will be a material strain on the
district’s thin cash flow margins,” Moody’s said.
So Nguyen expects “a lot more defaults at the local level this
year.”
Nguyen said the increased number of GO defaults should translate
into more opportunities in the high yield space he specializes in.
In fact, “In the next couple of years, we actually think some of
the high yield opportunities are going to be in the more traditional
muni sector.”
Given GO bonds’ higher recovery rates relative to high yield muni
bonds, when GO defaults occur, they will offer opportunities with “much
better” recovery rates.
MMA noted that “There are 4 GO/Lease bonds in payment default at
present, several others tapping insurance or reserves to cover debt
service.”
It also warned that “While we (thankfully) have yet to see any
2012-issued bonds in our database, underwriting patterns — rapacious
demand for yield, scarcity of product, overwhelming high-yield fund
inflows — do imply more risk of credit problems in the future.”
“The implication is for current primary market buyers to not only
1) be more careful regarding legal covenants and projections; but also
to 2) broaden diversification strategies for purchases this year; 2)
move more aggressively to take gains in risky-sector 2012 holdings; and,
3) generally understand that, all else being equal, the 2012 vintage may
require more analyst/workout costs going forward.”
However, portfolio managers at Eaton Vance and DWS Investments see
low risks for the muni market.
In fact, with credit spreads attractive by historical standards and
interest rates unlikely to rise quickly in this slow-growth economic
environment, DWS Investments Fixed Income Chief Investment Strategist
Phil Condon believes it is a good time to take some credit risk as well
as maturity risk.
As a result he favors ‘A’-rated municipal bonds and the longer end
of the curve.
Not to mention the possibility of higher taxes from next year
should Congress let the Bush-era tax cuts expire at the end of 2012.
Eaton Vance co-director of Municipal Investments Tom Metzold told
MNI that with taxes in the U.S. expected to increase, the municipal tax
exemption will take a greater value and that is not properly priced into
current market prices,
He is also taking advantage of the declining supply relative to
continuing growing demand for municipal paper, especially at the longer
end of the curve.
Still, flows towards muni bond funds have been slowing.
Bond fund data provider EPFR Global Research Director Cameron
Brandt told MNI muni bond funds took in $159 million in the week ended
April 18, bring the year-to-date inflow to $16.77 billion.
Asked whether he saw evidence that expected higher taxes are
boosting inflows, he said it was too early.
“Furthermore, some of the ideas for tackling the deficit include
ones that are not good for munis – tweaking or revoking their tax exempt
status, more cuts in federal aid to states, etc,” he said, “and may
deter people from jumping in before they know what’s on the table.”
the Senate Finance Committee will address the issue Wednesday in a
hearing at 10:00 am ET titled “Tax Reform: What it means for State and
Local Tax and Fiscal Policy”.
And in remarks submitted to the Senate Finance Committee in
preparation for the hearing, a coalition of local government groups
urged Congress to maintain the exemption.
“It is also important to adopt reforms that will allow local
governments to retain authority over their own tax policy,” the group
said.
“We would strongly urge you to oppose federal initiatives that
would preempt state and local taxing authority and grant certain
industries preferential tax treatment at the expense of other
taxpayers,” the organizations said. “By granting any one industry’s
request for federally mandated favorable tax treatment, Congress would
open the floodgate to many other similar requests, which would further
erode state and local revenues and undermine their tax policy.”
The group includes the National Association of Counties, the
National League of Cities, The United States Conference of Mayors, the
International City/County Management Association, and the Government
Finance Officers Association.
** MNI Washington Bureau: 202-371-2121 **
[TOPICS: M$U$$$,MFU$$$,M$$FI$,MP$$$$,MR$$$$]