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Muni Defaults Not the Start of Broader Trend

Jeremy Glaser
Jeff Westergaard

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Should muni investors be worried about credit risk? I'm here today with Jeff Westergaard, Morningstar's director of municipal analytics, to look at some of the trends in that space. Jeff, thanks for joining me today.

Jeff Westergaard: Thank for having me, Jeremy.

Glaser: So let’s start by looking at credit risk. Recently there's been a few more high-profile cases, such as Stockton, Calif., and elsewhere, where we’ve seen some municipalities go into bankruptcy. Is this a sign that we’re in big trouble and municipal investors need to be very cautious, or are these more isolated incidents?

Westergaard: Well, as you point out, these are really some kind of shocking developments in the municipal market. I think for investors one of the key things to remember is this is an incredibly diverse, very, very wide, very broad market. So when we say municipal bonds, it can mean a whole host of different types of securities.

That being said, municipal governments, in particular, have been under pretty severe stress as a result of the financial crisis, in fact, the worst stress since the Great Depression. I think, in the case of Stockton and in the case of San Bernardino, Calif., you certainly are seeing those stresses being reflected in bankruptcy, which in and of itself is very, very unusual for municipalities to actually declare.

That being said, we don't believe that this is the start of some pervasive wave of bankruptcies across the country. In fact, we think the asset class overall remains extraordinarily safe in terms of risk of default.

Glaser: But are there certain areas, certain types of bonds that concern you more than others?

Westergaard: Well, I think there are some areas that are concerning. Puerto Rico we feel is still very much an at-risk type of credit. It has a long history of challenges in terms of both financial management and the economy of the territory. There's recently been some key legislation passed in Puerto Rico, pension-reform legislation. The pension status in Puerto Rico is far and away the worst of any state in the United States So this is definitely a step in the right direction, but I think the jury is still out on whether Puerto Rico has really turned the corner toward improving its credit quality.

Away from that, you certainly have seen some of the California Central Valley communities. We talked about Stockton and San Bernardino that have fallen under hard times as a result of the housing bubble being popped. But, by and large, we don't really see anything that we would say is a pocket of severe risk that we would try to avoid.

Glaser: So if credit risk seems like it's mostly contained, depending on where you're looking, what does that mean about valuations? Are there attractive values in municipal bonds today in relation to other fixed-income asset classes? Where do you see this space generally right now?

Westergaard: Well, another interesting phenomenon that's a result of the financial crisis is that municipal yields have actually been higher than Treasury yields for quite some time now. Over the course of the last, let’s say, 30 to 40 years that wasn't the case. So one can make the case on a relative-value basis that municipals actually are quite attractive vis-a-vis Treasuries. If you look at a 10-year municipal yield for a AA, AAA rated bond right now, you can get 2% in most new issues. It's about 3.25% on a tax-equivalent yield for someone in the highest 39% tax bracket. So you're looking at Treasury bonds with less than 2% yield and municipals at 3.25% tax equivalent. I think you can make case it's a fairly compelling return to investors. That being said, interest rates, of course, right now are very low across the board, and I know many fear that that is not going to be the case as the Fed unwinds its easing.

Glaser: So when we think about the risk from rising rates, if you were looking at the relative attractiveness of taking on perhaps more credit risk, looking at lower-rated munis versus taking that duration risk, where would you place your bets right now? What are your thoughts about that?

Westergaard: There’s certainly been some compression between different rating curves in the muni market. I think that AA rated munis probably offer a good combination of risk and return vis-a-vis lower ratings. Certainly, it’s  typical in a rising-rate environment to see those credit spreads widen out and that compression be reversed. So I think, obviously, investors should be investing to meet whatever their particular investment goals are. But, as a general statement, I would say it would be safer to remain higher up on the credit scale.

Glaser: What does the supply and demand in the muni market look like right now? Are there a lot of new issuances able to sop up the demand for these bonds right now?

Westergaard: Yeah, the issuance to date so far in 2013 has been roughly equivalent to what it was in 2012. A lot of that is being driven by what are referred to as refunding issues, so these are municipalities or issuers looking to take advantage of low rates and refinance existing debt. In fact, for 2012, refinancings constituted the majority of all the deals that came to market. That being said, really we saw an anomaly in 2011 of a severe drop-off in the issuance. But if you look over the past seven years or so, issuances remained in a fairly narrow band of about $375 billion to $420 billion a year. That's high by historical standards, but it seems that's pretty much the new normal. So away from 2011, it’s pretty much business as usual at least with this new normal.

Glaser: Jeff, I really appreciate your thoughts.

Westergaard: You bet. Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.