Efficient markets are something of an absurdist joke to me. Markets swing wildly based on supply and demand issues, in reaction to changes in unrelated asset classes or in search of safety during period of political turmoil. And markets love a good story, even if that story is no longer true.
The municipal bond market has a fantastic story: tax-adjusted yields with a historically low rate of default. And look, yields have been dropping, which must clearly indicate a vote of confidence from the market on the credit quality of municipal debtors. Like all good stories there was once some truth to it, but things have changed.
A recap of the trouble spots in municipal finance:
Continued Economic Weakness: U.S. GDP growth in the last quarter for which QE2 was in effect was 1.0%. The August ISM numbers show the New Orders, Order Backlog and Production indexes all indicating contraction.
Credit Risk Transfer: Risk mitigation techniques are fantastic, but they only pass off losses to another party. If the risk of municipal default has been grossly underestimated, as I believe it has, the solvency of counter-parties must be considered.
Historical Default Rates: A discussion of the very low default rates municipal bond holders have enjoyed for the past few generations seems to conveniently ignore the last severe banking led downturn: the Great Depression. A historical analysis that conveniently ignores the last relevant financial contraction of the current type is useless.
Lagging Impact of the Downturn: A recent report by Ascent Investment Partners noted that: “financial performance of municipalities has typically lagged the national, state and/or regional economy by 18 to 24 months, resulting in cyclical lows for municipal finances approximately two years after the depths of an economic downturn.” To date, municipal finances have been the beneficiaries of a delayed reaction to the full impact of the 2008-9 recession thanks to the lag of property tax assessments and federal stimulus spending. Both of those props have now been removed, and absent an economic recovery that remains much discussed but little seen, the budget woes of municipalities will only increase.
Limits of a Capital Markets Orientation: The danger of citing the capital markets in support of a thesis is that the capital markets are constantly providing feedback, but much of it is white noise. Efficient market theory states that all available information affecting a security is reflected in the price of that security. Of course, if this were true hedge funds and private equity firms would be impossible. Howard Marks of Oaktree Asset Management further sheds light on this issue by noting that markets are severely challenged in reacting to multiple stresses simultaneously. A flight to perceived safety resulting in depressed yield for a group of debtors whose mid-term financial outlook is bleak is a perfect example of just such a failure.
Pension Obligations: The Baby Boom generation is preparing to retire, and for municipal governments across the country that raises the specter of underfunded plans that will never catch up, and rising health care costs that cannot continue to be met. These obligations need to be restructured, and they will be.
Taxing Authority: The ability of municipalities to raise revenue through taxes and fees has important practical limits. Local government officials and their elected leaders are likely to feel more accountable to voters and other constituencies over bondholders. Attempts to legislate around this bias (in Alabama and Rhode Island, for instance) have not yet been tested by the bankruptcy courts.
The credit worthiness of municipalities post Great Recession and post Boomer retirement wave will be lower throughout much of the country. Shockwaves in other corners of the debt markets may drive investors toward what they perceive as relative safety, and in the process drive down yields, but in the long-run the financial prospects of this class of debtor will only improve through a restructuring of bondholder and pension liabilities. Luckily, the market has a wonderful mechanism for dealing with increased risk in an asset class: demanding higher returns.
For all the flaws associated with it, S&P’s downgrade of the U.S. should serve as a wake-up call to all classes of bondholders that there is no risk free return, and that we have entered into an economic environment sufficiently different from all other post-Depression downturns as to demand more due diligence and deeper thinking from all parties.
About the author:
David Johnson is a partner with ACM Partners, a boutique financial advisory firm providing due diligence, performance improvement, restructuring and turnaround services to companies and municipalities. He can be reached at 312-505-7238 or at [email protected].
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