US municipal bonds paid tax-free interest which made them a very attractive investment. But now, suddenly, investors are selling off what was hitherto considered a generally safe instrument. What went wrong?
How safe is safe? For millions of investors all around the world the goal is not to make a killing in the markets, but to preserve and perhaps slowly grow hard-earned savings. In the United States, one asset class has long been considered to be one of the safest of all. These assets are called municipal bonds. They make up an almost $3 trillion market, two-thirds of which are owned by individual investors They have put their faith in the ability of local governments to get their sums right and their power to tax if they do not. But has this faith been misplaced? And if it has, what lessons are there for fixed income assets throughout the world?
Municipal bonds, or as they're called "Munis", are the debt obligations of the states of the United States and political subdivisions, like counties, cities, and towns. They also include certain projects like utilities or roads and even religious, educational and other charitable organisations like hospitals. Depending on the law of the individual state, the interest income from these bonds is tax-free. The combination of tax-free income from what is generally considered a very safe investment is often irresistible.
They have also been profitable. During the great bond bull market from 1982 to 2008, they paid interest and increased in value. Since the default rate has been negligible, the predictions last fall by high-profile analyst, Meredith Whitney, of a 3% default rate caused a furor.
So what is the reality? Why did so many retail investors, fund managers and other investment professionals consider this market totally safe and what went wrong? What perhaps went wrong was that the three assumptions underpinning this asset class either never existed, have disappeared, or have come under question.
The main problem with this market is transparency. The market is made up of over 17,000 issuers. Most of them are quite small. So they are not covered by any analyst and often not even by a local journalist. They are all also unregulated. The main security law in the US, the Securities Act of 1933 exempts these entities from the rigorous registration required for private issuers and the required ongoing reporting and disclosure.
The result of this lack of regulation is predictable. According to another recent study reported in The Wall Street Journal, "56% filed no financial statements in any given year between 2005 and 2009. More than one-third of borrowers entirely skipped three or more years, and the number grew to 40% in 2009, as credit woes mounted. Another 30% filed extraordinarily late in 2009." One utility from the state of Tennessee didn't file a disclosure for 10 years and then reported a default. The financial records of these issuers including cities, states, hospitals and other borrowers may not be audited, may not be accessible and may not even make sense.
This lack of transparency was not considered that important, it has always been assumed that a government would simply increase taxes to pay bondholders. Bankruptcy at least for states is impossible. However, many of these issuers, specifically the nonprofit entities, do not have the power to tax. Worse some of them like hospitals depend upon reimbursements from cash-strapped political entities.
Besides the assumed government guarantee, often these bonds were insured. They were insured by a few companies that specialised in this area. Called "monoline" insurers, these companies were considered as dull and as safe as the assets they insured. These companies were also regulated by state insurance commissioners. Unfortunately, they branched out into risky mortgage-backed securities and collateralised debt obligations. Most collapsed during the crash. In 2005, 57% of new bonds were insured. Now only 7% are covered.
The third pillar that supported the perception of safety was the opinion of the rating agencies, like S&P and Moody's. While the agencies' analyses of corporate debt have been accurate, their ratings of structured securities, sovereign debt and municipal bonds have not. Basically the investment community assumed that both the rating agencies and the regulators had access to sufficient information to assess risk. They did not.
The muni mess in the US is not a local issue. It's hardly surprising that governments around the world exempt themselves from rules they set for everyone else. Governments have just as many incentives as everyone else to obtain capital as easily and cheaply as possible. Without rules, regulation or scrutiny, the present environment of defaults of sovereign and quasi government debt is quite predictable. What is astonishing is that investors have mispriced the risk. The problems in the eurozone and the US municipal bond market should be a warning especially for debt in emerging markets. Complete safety is a mirage and a true reflection of risk should be a higher return.
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected])