Changing Fortunes in the Muni Market

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Municipal-bond fund investors have been on a wild ride during the past several years. Joining me to discuss the municipal market's changing fortunes is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Hi, Christine. Good to be with you.

Benz: Eric, you recently wrote a piece in which you talked about pre-financial-crisis muni correlations. Munis were fairly well-correlated with the Treasury market. Why was that?

Jacobson: Well, in some ways, investors viewed the municipal market as being a lot like the Treasury market, and the underpinning of that was that for many years prior to the crisis, you had somewhere between 50% and 70% of all the new issuance coming wrapped with insurance from third-party companies. Essentially what that said to investors was not only do you have the underlying quality of the issuer, whatever municipality is, but you've got the protection of this insurance agency, most of which were AAA rated and were around for years. Essentially the bonds got treated like AAA bonds in the marketplace, and because of that, logically if you think about it, something that has a AAA rating tends to trade a lot like other AAA bonds, which is where the U.S. government was, as well. So, they were very highly correlated.

Benz: So, the wheels came off that assumption, though, during the financial crisis. Let's talk about what happened there and what led to munis becoming decoupled from the Treasury market.

Jacobson: At least in the short term, one of the big things that happened is that a lot of highly rated municipal bonds had been held in what we call leveraged structures. They were held by hedge funds and other investors, and when a lot of these leveraged investors needed to "unwind" their leverage by reducing their borrowing and so forth, they had to sell out all the underlying collateral. In many cases, where there were munis involved that meant that there was indiscriminate selling of very high-quality munis. So, at the same time during the crisis that high-quality Treasuries were being purchased en masse, investors were selling municipals, and that was a major rift right then and there between them.

The other thing that happened is that the insurance companies about which we just spoke had been badly damaged by the crisis. Several of them had gone out and written insurance on mortgage pools that had nothing to do with their municipals businesses. But because they were so put in such peril by the mortgage crisis, many of them hit the skids. They were either downgraded, or went out of business, or what have you, and suddenly you had this huge portion of the market that had been wrapped with insurance that no longer had insurance. The market was sort of sputtering around, looking to figure out where the bonds should trade, and ultimately not like Treasures is what happened. You had a lot of cases where the underlying credits weren't even that bad, maybe they were only AA instead of AAA, but suddenly investors treated them all very differently. You had this big rift between them, and it really created a strange and different market where correlations went down to nearly zero.

Benz: Treasury investors had a very good experience during the crisis, really it was one of the only assets, the only asset, that did particularly well during the period. Munis didn't perform nearly so well, and in fact, muni funds in some cases had losses, maybe even sizable losses.

Jacobson: That's exactly right. In fact, it was an even bigger problem, just as a side note, for funds that were hedging, and when I say hedging, what I mean is many of them had bought a lot of long-maturity municipals and then sought to hedge their interest-rate risk back with Treasury futures or other items. Because those are essentially negative bets on Treasuries, both sides of the portfolio went bad at the same time. Their municipals were getting sold off at the same time that these Treasury futures and interest-rate swaps were going down because Treasuries were going up. Those were some of the worst cases of all, where people hoped that they had some protection with the hedging that was going on, but it wasn’t to be.

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