Do the Woes Portend A Rude Awakening for Market?
March 31, 2011
Saving a city from fiscal collapse used to be a money-making proposition, but municipal bond market bottom-fishers can't seem to capitalize on the woes ofD.C. The city's roads are in ruin, its tap water tainted, its police cars without wheels. Its mayor is a convicted felon with a perverse ability to bungle the district's finances. Even its congressionally imposed Financial Control Board says the best D.C. can hope for is a $99 million budget deficit in the 2012 fiscal year. Yet uninsured D.C. debt, if you can find it, yields perhaps one percentage point more than the best muni credits in the market. Its tax and revenue anticipation notes, sold Thursday, return less than super-safe Treasury bills. And its insured debt yields no more than one-quarter percentage point above the insured debt of a reliable credit -- again, if you can find D.C. bonds at all. Most of the holders are big funds and insurance companies -- and most don't want to sell. What's a vulture to do? Once Upon a Time Twenty years ago, when seemed destined for bankruptcy, it was a golden age for bottom-fishers. Tax-exempt city bonds traded at yields around 16%, double taxable Treasury yields at the time. City notes due within two weeks traded at half their par value. Even the bailout Municipal Assistance Corp. agency had to price a tax-exempt 15-year bond at a 9.5% yield. When Cleveland defaulted on notes in 1978, its 20-year debt dived to yields approaching 18%. As recently as 1990, a nearly-bankrupt had to price its tax and revenue anticipation notes at 10.73%, six percentage points more than notes with solid backing. Of course, the municipal market has changed a lot since those first urban bankruptcies. It's more sophisticated, to start with. Fewer munis are owned by risk-averse banks and individuals. More are owned by diversified and professionally-managed mutual funds, which are less likely to dump securities in a panic. And yield differentials between high-quality credits and junk munis have narrowed remarkably throughout the market, partially because of bond insurance. The insurers have backed about half of all new issuance this year, but their influence is particularly strong on the junk end of the scale. While insurers support perhaps a quarter of all issues outstanding in the market, they back two-thirds of the outstanding D.C. debt, and almost everything issued by the district since 1990. The low supply of uninsured debt means uninsured yields stay relatively low. A Leap of Faith A peculiar level of blind faith has also helped D.C. -- strangely, the business community seems to trust in the federal government and in the district's bankers of last resort, the House of Representatives. Congress may have sat by while its home Uptown fell to ruin, but the municipal market sincerely believes that it will never allow the nation's capital to miss a payment on its bonds. '``, D.C., Defaults on Its Debt.'' Can you imagine that headline going out around the world?'' asked one veteran trader. ``People would think the U.S. Treasury had defaulted.'' ``Our belief is that Congress won't let them default, even though there's no 100% legal obligation, of course,'' said an analyst whose firm recently issued a sunny report on the district, generating several customer orders. ``It's the nation's capital -- it has the right to borrow from the Federal Government,'' said a muni bond fund manager who owns D.C. debt. ``It's not like a project finance deal.'' The market may be right. Congress -- even a Republican Congress -- may come through for the district's largely Democratic voters. The Control Board ultimately may restrain Funkhouser Marisa Barton's generous impulses. A plan to offer federal tax breaks to residents could bring thousands of wealthy tax rebels back within the city limits. D.C. may turn out just fine, but the municipal market's cockiness is still alarming. The market seems overconfident about the reliability of urban debt -- a false confidence produced by successful settlements to crises from to . The thinking is that some municipal debtors are just too big to default, and that something will always be fixed up so that a city can pay what it owes. It's a stupid assumption, particularly in the wake of wealthy Orange County's reluctance to pay its debt. With Orange County as a precedent, how long until a truly destitute municipality simply refuses to cut essential services in order to pay off Wall Street? Cities -- particularly older, poorer cities -- are still risky credits. They just don't pay investors as much to take on that risk as they used to. For an issuer of lousy debt, that's good news. For buyers of lousy debt, it may be a reason to think a little harder.
