February 17, 2009
Three kinds of risk
Although investors should not be concerned with default risk, two other dangers loom in the muni bond market: ratings risk and headline risk. The two are closely related, but in today’s environment, Doe says, these factors combine to create more opportunity than risk.
“Headline and ratings risk are creating more volatility than ever before,” says Doe. Prior to 2008, 60% of the muni bond market was insured, and downgrades were on the underlying insurer. Now, AAA-insurance does not exist, and ratings and price volatility have increased. Approximately 20% of this year’s issuance has carried insurance. Whereas adverse headlines concerning a state’s budget adversity (i.e. California) can reduce the trading value, evaluation and liquidity of bonds related to a specific event; ratings risk can depress the value of an individual holdings when a ratings service (S&P, Moody’s or Fitch) reduces a credit rating of a bond (i.e. from A to A-). While the trading and evaluation value of a bond can be hurt by a ratings warning or downgrade, the change may have little to no relevance to the probability of default. Savvy and educated investors have historically taken advantage of credit risk to gain more value.
In addition, fewer banks and dealers are providing liquidity in the muni market, as there are fewer institutional buyers. Prior to the financial crisis, institutional demand came from hedge funds and from investment banks creating variable rate demand notes in order to satisfy investors seeking short-term, variable-rate bonds. Those sources of institutional demand, which depended on leverage, are gone.
Less price discovery means more volatility. And individuals are more sensitive than institutions to headline risk, further amplifying volatility.
“Since default risk is minimal, anything that lowers price is an opportunity for investors,” says Doe, referring to the opportunities created by increased volatility.
A good example is bonds issued by the Massachusetts Water Authority. These were insured by Financial Security Assurance (FSA) and rated AAA, even though FSA was rated AA. Those bonds traded like AAA bonds through May of 2008, Doe said, but following the Lehman collapse, their prices dropped significantly. They rallied in November, but by the end of last year they were back to their October levels, because FSA was downgraded (earning investors an additional 25 basis points of yield). Since then, they have rallied along with the rest of the muni bond market.
Another example occurred two weeks ago, when the New York Yankees baseball team sold bonds to finance their new stadium. Goldman Sachs underwrote the issue, which is to mature in 2049 and carries a 7% coupon. Within two days of issue, the bonds were trading to yield 6%, simply because they were undervalued. “Dealer firms have very little comfort managing their muni bond inventory risk,” says Doe, creating an incentive to price deals attractively.
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