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Municipal-Bond Landscape Shifts

Correlation with Treasuries is climbing back to precrisis levels, which should concern muni investors.

Eric Jacobson, 08/20/2012

One of the most notable effects of the 2007–09 financial crisis was the dramatic disconnect that developed between the municipal-bond and U.S. Treasury markets. Intriguingly, munis and Treasuries have recently begun to converge. That’s been good news for muni investors, but it signals some potential risks.

The Landscape, Precredit Crisis
Before the crisis, most investors rightly viewed the top tiers of the muni market as highly correlated with Treasuries. For many years, the majority of new muni-bond issuance had been rated AAA. With a discount owing to the tax-advantaged status of municipal interest payments, the average yield for an AAA municipal bond was typically even lower than that of a comparable Treasury bond. So, even though institutional investors didn’t typically benchmark municipal yields directly to those of the Treasury market, shifts in the latter almost always had a direct impact on the former. It’s fair to say that most individual investors even viewed AAA munis and Treasuries as substitutes for one another.

Much of that AAA municipal issuance was blessed with the pristine rating thanks to third-party insurance. If municipal entities purchased insurance from highly rated companies to support their bond issues— thereby offering additional guarantees to investors that their interest and principal would be paid—they could issue bonds at lower rates than they would have otherwise. This was such a common practice that well more than 50% of new bond issues came with insurance in any given year. By 2005, nearly 70% of the market value of the Barclays Municipal Bond Index garnered AAA ratings from outside agencies.

Credit Crisis Alters Landscape
Everything changed after the onset of the financial crisis. Initially, one issue was the overall deleveraging taking place among investment banks and large investors around the globe. Indiscriminate selling of anything that wasn’t a U.S. Treasury bond was the order of the day, and the muni market wasn’t immune. In particular, many hedge funds were reported to have unwound highly leveraged trades in the muni market, and their sales pummeled the prices of even the most highly rated bonds.

Just as critical was the sudden lack of faith in bond insurance. Eager to increase revenues and profits, AMBAC and MBIA, the leading providers of third-party muni-bond insurance, had branched out into other sectors of the bond market, writing massive amounts of insurance on mortgage securities that weren’t guaranteed by government agencies. When it became clear that these insurance companies had overex- tended themselves, they were downgraded by the ratings agencies. That shock left billions of dollars in bonds without the perceived protection of the insurance companies. Not only did the ratings on insured munis typically fall to match the credit of their underlying issuers, but in the resulting panic, investors also marked many bonds’ prices down further, even below where the new, lower ratings implied they should be.

Within a relatively short time frame, the entire face of the muni market changed. Whereas AAA bonds had dominated the space as recently as 2007, their share of the market tumbled as bonds were re-rated into lower tiers (see Exhibit 1 below). The AA and A rated cohorts were the largest beneficiaries of the shift, with the former taking up more than 50% of the market by March.

The Aftermath
The credit-crisis deleveraging has had a long-term impact as well. Many fixed-income mutual fund managers report that liquidity has declined across the bond market from precrisis levels. One culprit seems to be investment banks’ decisions to cut risk and commit less capital to market-making activities. Many banks also argue that these moves are necessary to comply with new laws and banking rules that are expected to be enacted. Whatever the catalysts, the trend is clear: The Municipal Securities Rulemaking Board reports that trades (by par amount) declined by more than 41% between 2008 and 2011.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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