Interest Rate Risk and Credit Risk: Is There Danger in the Muncipal Market?
Brian Battle, Performance Trust Analytics Group
As famed investor Warren Buffett has said, “You only find out who is swimming naked when the tide goes out.” With interest rates historically low but rising, stressed municipal credits are being revealed in this slow growth economy. So, at times like this, how should you be thinking about municipal bonds? Should you be buying, selling, or sitting tight? Certainly, interest rate risk can be managed by implementing a disciplined, forward-looking analysis that doesn’t depend on an interest rate call. But what about that other risk––credit risk––and ultimately, the risk of non-payment (default)?
Back to March 2017 CFO & Finance Digest
The U.S. has been experiencing an anemic sub-3% growth rate for the last eight years. This macroeconomic measure matters to municipal buyers, since municipal governments run on property taxes, sales and use taxes, and personal income taxes. Slow/low/no growth is corrosive for a municipality’s creditworthiness. But these effects are not equal across all municipal borrowers. For example, a number of states, particularly in the Far West, continue to log robust tax revenue growth. California (Aa3 stable), Colorado (Aa1 stable), Oregon (Aa1 stable), and Utah (Aaa stable) are among these outperformers. Where is credit risk lurking in the municipal market? We can affirm that there is risk, but it isn’t hiding, and you likely don’t own it. Highly regulated depository institutions do not own these types of credit risks.
The municipal bond market has tens of thousands of different issuers scattered across the country, and there will always be suboptimal borrowers and stressed credit. Some stressed municipal issuers are running out of money due to limited growth and higher spending, along with lower income, sales, and property taxes. These types of speculative municipal bonds in question tend to be held directly by individuals, high-yield mutual funds, or sophisticated portfolios. This is not unexpected, since mutual funds are naturally more diversified and can offset such risk though a large number of unique holdings. These near-default and at-default borrowers and their creditors (bondholders) face a highly uncertain and uncharted path. Some defaults are setting precedents and in recent cases, such default outcomes have changed for the worse compared to the limited historical data. Post-default recoveries for bondholders have also changed; the path to recovery on a municipal default has left the confines of traditional legalities and has now entered the political realm. In bankruptcy, unsecured creditors vie for limited resources. If bondholders get more, pensioners get less and vice versa. In these scenarios, pensioners will seem to be a more sympathetic creditor class. Populism will rule the day in bankruptcy court, and those bondholders will experience suboptimal outcomes. There is evidence that you can measure credit risk and interest rate risk, but you can’t measure political risks.
Choosing the right strategy
While high-quality portfolio holders can’t control the political environment, either, you can intentionally create a geographically diversified portfolio to offset the regional risk where municipal distress might increase. Municipal distress in high-quality bank portfolios will mainly be felt as spread widening if there is an erosion on credit ratings or perceived credit quality. Make sure your policy has specific limits around issuer and geography concentrations. This is one way you can immunize your investment portfolio against any unexpected or unforeseen events. The municipal market is a massive, $3.6 trillion market, and most issuers are in good financial condition. Action must be taken now to preemptively inform your investment committee that there will be more spectacular muni headlines, and that your investment policy protects you from these types of surprises. Distress and defaults will increase, but this does not need to be the case for your institution as long as you assiduously codify an investment policy that evades credit risk as well as an interest rate strategy to manage market value volatility, regardless of what happens to interest rates.
Brian Battle is the Chief Muni Strategist for Performance Trust Analytics Group. He can be reached by phone at 312-521-1624 and by e-mail at email@example.com