Home>Video>Yellow Flags for Nonrated Munis

Yellow Flags for Nonrated Munis

Thu, 30 Aug 2012

Despite their extra income, nonrated municipal bonds can expose investors to lower-credit-quality, less-liquid issues with a tremendous research requirement, says Morningstar's Eric Jacobson.

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Video Transcript

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. The Federal Reserve Bank of New York recently reported the default rate for municipal bonds was actually much higher than had been previously reported in part because earlier data didn't include so-called nonrated municipal bonds.

Joining me to discuss nonrated munis is Eric Jacobson. He is director of fixed-income fund research for Morningstar. Eric, thank you so much for being here.

Eric Jacobson: Great to be with you, Christine.

Benz: Eric, this Federal Reserve Bank of New York report looked at the total muni universe, and what they found was that once the nonrated munis were added back in, the default rate was actually a lot higher than figures that had been previously bandied about. The question is, Eric, why are there these nonrated municipal bonds? Why do municipalities choose to go without ratings?

Jacobson: Well, the main reasons have to do with size and cost. Most of those deals are very, very small deals relative to what you would think of as being Wall Street bond deals, and the cost of paying for the rating is typically very, very high relative to the value of the deal that it’s going through. So, they are already paying an extra premium for putting out a small deal from a relatively unknown entity, and to have to pay for the rating in many cases would be prohibitive. That's especially so if the quality of the deal is in what we might call the lower-rated or junk territory. In those cases, it seems doubly needless for them from their perspective to pay up for a rating because they know that they are not going to be included in the normal ebb and flow of individual bond buying or the portfolios of very high-quality mutual funds.

Benz: Eric, you also noted that the sector complexion of the nonrated muni-bond universe tends to be different than the whole muni-bond universe. Let's talk about that. What are the differences and what sorts of municipal projects tend to be the big issuers of some of this nonrated debt?

Jacobson: The first thing to think about is the fact that the rated universe includes most of the municipalities that most people would think of, your cities and your states and so forth. Most of the nonrated universe are bonds that are not directly backed by your common municipalities. Oftentimes what you have is a municipality lending its name and its tax status to a deal so that it can be issued under the rubric of the municipality, but the ultimate credit quality and the responsibility for paying back the bonds is shouldered by some special entity, whether it's a corporation, whether it's a housing project development, whether it's a nursing home or hospital. There are a wide variety of issuers.

It could even be a corporate entity. The airline industry, for example, has a lot of these issues outstanding, and in that case the drivers of how they act and how they perform are going to be very different than your typical municipality that has taxing power available to it.

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Benz: Looking at this recent data about the default rate among nonrateds as well as what you were saying which is that some municipal projects may forgo the rating because they know that they're not necessarily the highest quality or that they won't receive a high rating, should investors feel risk-averse if they're looking at say a municipal-bond fund and it has a big share of these nonrated bonds? Is this a red flag for investors?

Jacobson: Yes. I would call it a yellow flag to a red flag depending on what you're looking at. There are quite a variety of funds in what we call our high-yield municipal category. And when I say variety, what I really mean is different levels of risk that they take on. There are some that have 20% to 30% high-yield or nonrated bonds, and there are a few that go all the way up past 50%. Those that take on almost half of a portfolio worth of nonrated bond risk are really, really taking on a gargantuan task because it requires a tremendous amount of research, and you don't have any really third-party research to lean on to sort of help you figure out even the area that you're dealing with. You've got to start from scratch.

Benz: The trade-off here is that in some cases the yield is higher in exchange for the extra risk that you're taking on by venturing into nonrated munis?

Jacobson: You're getting that extra yield as a result, oftentimes of the lower credit quality and the general fact as you say that it doesn't have a rating and that the bond is likely to be less liquid than a big, large rated deal. So, you have to get paid for all those things, and that's where the extra income comes in.

Benz: So, how about for individual bond investors, I'm guessing you would say that they should steer clear of nonrated munis, that they should stick with, at least munis with ratings?

Jacobson: Yes, I really think so. I think for one thing there is always going to be a liquidity component with very, very small deals like that without ratings. They might be very hard to sell if you need to, and again it comes back down to this research issue. You'll be on your own if you're going buy a nonrated bond. You really have no idea. There is such a thing as a nonrated bond that has a higher quality, they just haven't paid for the rating. But you don't really know if that's what you're buying unless you're able to dig in and do the research.

Benz: If it's a fund that has a high share of nonrateds, you're saying you really want that firm to have some known ability in that space to find good credits and make sure that they're not just falling for higher-yielding, but very risky, bonds?

Jacobson: That's right. There are probably few other places in the universe of bond funds where research matters more. Certainly, it matters a lot in other places, but for sure in this universe you've got to have a good large broad team that knows different sectors and has enough manpower, people power to get out there and do the research. And ideally you want a firm that has a reputation for doing a really good job with credit.

Benz: Eric, well thank you so much for sharing this guidance. I know that our users are very attuned to munis especially given the potential threat of higher taxes down the line, so this is very timely guidance. Thanks for being here.

Jacobson: Glad to be with you, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.


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