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By Christine Benz and Eric Jacobson | 08-30-2012 03:00 PM

Yellow Flags for Nonrated Munis

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.

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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