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Morningstar
Quarter-End Insights

Our Outlook for the Municipal Markets

Three key questions come into focus for the muni market, but one reigns supreme.

Jeff Westergaard
  • Regardless of which particular fixed-income market is of interest to investors, the single biggest question they face is how the Fed will unwind the liquidity support it has been providing.
  • Recently tax proposals have been put forth that would drastically affect the tax treatment of municipal-bond income.
  • Investors have historically  taken as an article of faith that the municipal market represents inherent safety, but lately that faith has been brought into question.

The municipal-bond market, once the sleepy domain of widows and orphans, has been on quite a roller-coaster ride since the implosion of world financial markets in 2007. Since that time, the market has gone through a number of shocks that have called into question many of the tenets that investors held true in the decades leading up to the crisis. Entering the third quarter, municipal-bond investors are once again facing uncertainty. Three topics dominate the outlook for the market. The first--the direction of interest rates--affects all fixed-income investors. The second and third--tax reform and credit risk--are uniquely municipal in nature.

All Eyes on the Fed
As for all debt markets, the role of the Federal Reserve and the overall level of interest rates in the economy directly affect municipal bondholders. The extraordinary measures that the Fed has enlisted during the past five years have created a low-interest-rate environment unseen since the 1950s. Regardless of which particular fixed-income market is of interest to investors, the single biggest question they face is how the Fed will unwind the liquidity support it has been providing. Whether we see a repeat of 1993-94 and the severe increase in rates that slammed the market or a more muted end to the extraordinary easing that has been in place over the past five years, most investors believe that we are nearer to an end of the easy-money regime than to the beginning. Already, as we write this, one-year Treasury rates have risen to 2.33% from a low of 1.43% on July 25 of last year. That 90-basis-point rise is significant on an absolute basis, but extraordinary when measured by the 63% increase in absolute terms it represents in the space of 11 months. For investors, this spike is a double-edged sword, as a rise in rates will result in lower values for outstanding bonds while offering the benefit of higher income levels than have been available for the past few years.

Tax Reform: Will the Need Triumph Over Politics?
Another potentially significant change comes in the form of tax reform, oft mentioned but rarely enacted. Virtually no one believes that our tax code, as currently constructed, is good for our country. There are few things that are so universally agreed upon these days as the need for a re-engineering of our system of taxation. Of course, translating that to actual reform is infinitely more challenging.

Not since the Reagan administration has the municipal market been faced with a significant rewrite of the tax code. The 1981 and 1986 tax code changes significantly altered the tax treatment of municipal bonds, introducing the alternative minimum tax and bank qualification as factors for municipal investors. Recently proposals have been put forth that would drastically affect the tax treatment of municipal-bond income, with the most significant being a limitation on the tax benefit at 28% of gross income. The primary drivers for municipal-related proposals have been revenue considerations and deficit reduction. In our opinion, this issue has lost some of the dominance it held from late 2011 through the election, though that may prove temporary. Whether there is consensus to move forward with these new radical approaches remains to be seen, given the partisan dysfunction in Washington, but investors would be well served to keep an eye on developments.

Paradigm Shift for Credit Risk or Temporary Reconstruction?
After coming through the turbulence of the financial crisis and ensuing recession, many municipal issuers find themselves under financial duress. In normal times these issues would be considered very significant, and rightly so. But there is one issue facing the market today that demands investors' attention: credit risk. Above all else is the evolving view of credit quality and whether there is a new normal at work that needs to be recognized.

One of the truly remarkable attributes of the municipal market in the period since the Great Depression is the relatively minor number and dollar amount of bond defaults that have occurred. While there have been notable exceptions, such as Washington Public Power Supply in the 1980s, for the most part municipal bonds have proved to be a very successful investment vehicle for return of principal. Investors have taken as an article of faith that the municipal market represents inherent safety. A further belief is in the supremacy of the full faith and credit general-obligation pledge of governmental issuers. The municipal market has benefited greatly from the faith on the part of investors that an investment in municipal bonds is one of the safest alternatives available. 

2012 and 2013: Shifting Perceptions on Credit?
Lately, that faith has been brought into question. June-July 2012 brought with it a renewed focus on credit risk and, in particular, the topic of municipal bankruptcy as three California issuers--Stockton, Mammoth Lakes, and San Bernardino--declared bankruptcy over the span of a few weeks. These were not the first bankruptcies in California in the wake of the financial crisis. The city of Vallejo, in the San Francisco Bay area, declared bankruptcy in 2008. While the declaration of bankruptcy by Vallejo was alarming to many, for bondholders the end result was relatively good. All debt service payments were made on time, and the city exited Chapter 9 in 2011. Furthermore, the prime cause of the situation was specific to the city in the form of employee wage contracts that the city could not afford to continue paying. There did not seem to be a systemic aspect to the situation that could apply to other municipalities on a widespread basis. Similarly, the filing by Mammoth Lakes was due to an unfavorable judgment in a real estate development lawsuit, certainly not something that could be perceived as posing systemic risk.

By contrast, the Stockton and San Bernardino situations do appear to present a more general danger. These filings highlight the lingering effects of the crisis and recession. In both cases, the cities are part of the Inland Empire, where the economic and housing boom that preceded the crisis was particularly strong. In the case of both cities, property values plummeted and unemployment increased dramatically after the crisis, placing intense stress on revenue and expenses. Despite the formal exit from recession by the national economy, many areas of the country remain financially stressed because of decreased housing values and pockets of economic weakness. Additionally, many states have decreased funding levels of transfers to local governments. This factor exacerbated the fiscal stress for Stockton and San Bernardino leading up to their bankruptcies.

The Sad Tale of Detroit: A Watershed Event Unfolding
While the California bankruptcies were ominous, they pale in comparison with what is currently transpiring in Detroit. In our opinion, the single biggest development in the municipal market post-crisis is this unfolding situation. Once the nation's fourth-largest city and synonymous with America's industrial prowess and center of automobile manufacturing, Detroit has been on a long and precipitous decline since the 1960s, culminating in a 25% decline in population between the 2000 and 2010 Census. Not only has the city seen an exodus of people and jobs, but the residential housing stock has been decimated, with scores of abandoned homes and rapidly depreciating home values depleting property tax rolls. Even those properties that are assessed on city tax rolls are only generating roughly half of the property tax revenue owed annually. Unable to reverse its economic malaise, the city has racked up ever-increasing liabilities while revenue declines. Despite years of attempts to address the fiscal deterioration, it was clear that the city had run out of options by the end of 2012. Faced with an untenable situation, the state of Michigan placed the city under the power of an emergency financial manager in March 2013. The state is one of a handful around the country that can legally take control of the finances of a local government. While the manager is imbued with significant powers under Michigan law, the situation in Detroit is very clearly a decision about bankruptcy and default. At this point, both appear inevitable.

It is hard to overstate the importance of what is happening in Detroit and the potential impact it has on the municipal-bond market. While some may view this situation as isolated and specific to a single city, we think there are bedrock beliefs in the market that are being challenged by the proceeding under way. How these play out over the course of this crisis has the potential to fundamentally change investor views of the creditworthiness of the municipal market. At the very least, we fully expect levels of uncertainty to increase, with the potential for a bifurcation in the market of credit haves and have-nots to evolve.

Character, Capacity, Collateral: What Ultimately Matters Most
Ultimately, the most important question is whether the obligation that issuers commit to bondholders has somehow lost its paramount importance. In simplest terms, a bond is a promise to pay from the obligor of the debt. That promise is based on three fundamental pillars: the willingness of the borrower to pay, its ability to financially meet its obligations, and the strength of the legal and contractual provisions that protect a bondholder.

In Detroit, the question of willingness to pay is less important than the potential treatment of legal and contractual provisions. In particular, how the city treats general obligation creditors, especially unlimited tax general obligations, has the potential to cause a significant rethinking of bondholder protection. If the city proceeds with the proposals the emergency manager has put forth, the unlimited tax general obligation bondholders will not receive the preferential standing that market participants believe they should be afforded. This would truly be a watershed event and certainly end up being decided in court.

All of these questions will take time to answer. Clarity will come through negotiations and legal maneuvering. However, we cannot help but see this situation as fundamentally different and more important than any previous example of credit distress since the Great Depression.

State of Bond Industry in Question
The state of the municipal market is one of extensive uncertainty. What happens with interest rates, tax reform, and the economy will all affect the municipal market. We would handicap the chances of tax reform as low, given the current partisan political landscape, but there is a chance that a grand bargain might be reached. The economy and the Federal Reserve are directly linked. An improving economy will be good for municipal issuers' finances but invariably lead to higher interest rates. Whether the bond vigilantes force the Fed's hand will bear watching, as well.

However, these things pale in comparison with the potential impact that the unfolding drama in Detroit holds for the municipal market. For the third quarter and beyond, the real question investors must ask is whether the cornerstone assumption of the legal pledge of full faith and credit by municipal borrowers can be reliable. We can't express strongly enough the importance we attach to what happens to bondholders as this situation plays out.

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