From the October 2008 issue of Investment Advisor • Subscribe!

October 1, 2008

Sleuthing Bonds

Explaining the recent market transformation

Furthermore, the correlation coefficient of the municipal to Treasury bond relationship has slipped from it's long-time average around 50% to below 0% recently, indicating that municipal bonds are now more likely to move in the opposite direction of Treasury bonds, where before the two markets commonly moved in the same direction.

Overall, volatility is higher than we have seen in many years. What explains the transformation of this normally quiet market into a sea of volatility? Well, it's a fairly long story, but I'll try to condense it as best I can.

First, most of the bond insurers got themselves heavily involved in the business of insuring mortgage-backed securities and collateralized debt obligations (CDO's) made up largely of mortgage-backed securities. They thought they understood the risks that they were taking, but apparently did not. They are now facing billions in claims that will be paid out over many years to come. No one knows the exact magnitude of the claims, but estimates range from about $10 billion to over $30 billion. For the most part, the insurers appear to have sufficient resources to continue supporting the bonds they insure, but it is possible that, in some cases, they do not. In any case, it seems that some, if not all, of them are not worthy of AAA ratings. Luckily, the municipal bond market can still function without the assistance of the troubled bond insurers.

According to recent reports by Moody's and S&P, 10-year cumulative default rates on investment grade municipal bonds have averaged less than 0.1%. So, in the vast majority of cases, the bond insurance is not necessary.

However, tax-exempt money market funds have grown highly dependent on bond insurance. These funds are restricted by Rule 2(a)7 of the Investment Company Act of 1940 to buying only short-term securities rated AA- or higher. Many issuers of the floating rate municipal bonds favored by money market funds relied upon the bond insurers to secure the ratings they needed. With the bond insurers getting downgraded or being placed on review for downgrade, money market funds started putting their variable rate bonds back to the dealers that marketed the bonds. When the dealers' balance sheets got too heavy with floating rate bonds, including auction rate bonds, they stopped supporting the market. This led to many auction failures and otherwise high interest rates on nearly all floating rate municipal bonds. When an auction fails, the interest rate on the bond reverts to a maximum rate defined in the bond documents. Since money market funds wouldn't buy auction rate bonds, other buyers had to be found, but in the meantime, many high quality issuers got stuck paying interest rates as high as 12% or 15% on their auction rate debt. This market has started to calm down of late, but many auctions are still failing and many issuers are starting to refund their auction rate bonds with fixed rate debt, adding to the supply of long-term bonds.

The Tender Trap

This leads us to the third phase of the cycle. Tender option programs have been among the largest issuers of short-term debt recently. These programs were created several years ago to provide a means of using leverage to amplify returns in the municipal bond market. They have been put together by hedge funds, proprietary trading programs, and some mutual funds (not ours). The basic structure is as follows: an investor acquires a large block of long-term bonds. Those bonds are placed into a trust, which sells floating rate securities with a tender option (they can be sold back to a remarketing agent) to money market funds and other short-term buyers. The investor holds on to a residual interest in the trust and earns a spread based upon the difference in yield between the variable-rate bonds and the fixed-rate bonds placed into the trust, magnified by the amount of leverage used. These programs produced double-digit yields for their investors when the yield curve was steep and when money market funds were willing buyers. However, with money market funds avoiding exotic structures and exposure to many bond insurers, the economics of tender option bond programs have been turned upside down. This has forced several large hedge funds and others to unwind the programs by selling billions of bonds into a market already suffering from a lack of liquidity. The enormous selling pressure overwhelmed the demand side of the municipal market, peaking with concentrated underperformance (particularly toward Treasury bonds) in late February. Since that time the market has recovered fairly significantly, although valuations are still relatively inexpensive and further selling pressure is still a distinct possibility.

Facing the Challenge

While short-term volatility has grabbed most of the headlines, long-term trends could prove to be more important going forward--28 states have announced projected budget shortfalls of $39 billion in fiscal 2009 according to the Center on Budget and Policy Priorities. The budget shortfalls are concentrated in states that were accustomed to very high growth rates in the housing-led boom that prevailed recently, but there are very few areas that are escaping weakness altogether.

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Budgetary reserve balances are generally healthy and many states are implementing hiring freezes and other means of achieving balanced operations, but we expect the credit environment to be challenging for at least the next couple of years. Some of the weakness will also affect credit on the local level such as for school districts and housing authorities, but so far the damage has been relatively contained and upgrades are still outnumbering downgrades.

As always, it is very important to monitor bond portfolios carefully and maintain broad diversification. In years past, investors got into the habit of relying on rating agencies for surveillance and bond insurers for credit enhancement. However, rating agencies have recently done a very poor job of accessing credit quality in many cases--witness recent trades in highly rated mortgage-backed product below 50 cents on the dollar. At Thornburg, we utilize the rating agencies but do not always rely upon them. Even good analysts sometimes miss important points, and timely surveillance is very difficult for the rating agencies to provide on over a million different issuers of municipal bonds.

As for the insurers, we believe that cheap bond insurance was a key component of the "commoditization" of the municipal bond market. The insurance policies they wrote may ultimately prove to be worth something, but the market is currently treating them like scraps of paper. Bonds are trading and priced predominantly based upon the underlying fundamental quality (or lack thereof) of the underlying obligors. This is the kind of market where experienced managers with the time, ability and inclination can produce significant value for their shareholders. Hopefully that value will be recognized some day, perhaps after tax rates go up!

The other trend worth noting is the rapid steepening of the yield curve (see graph above). As you know, the Federal Reserve has some control over short-term interest rates, but market expectations generally control long-term interest rates. The Fed has aggressively eased monetary policy recently while the U.S. and the global economy are facing rising inflationary pressures. This turn of events seems to be feeding market expectations of higher inflation down the road, which is leading to a greater risk premium on long-term bonds relative to short-term bonds thus the steeper yield curve. Given that the Fed seems to be predisposed toward extending its easy money policy while the weak dollar and other factors continue to fuel inflation, we think that the steep yield curve may stick around for a while.


George Strickland is a managing director for Thornburg Investment Management and co-portfolio manager of the Thornburg Municipal Bond Funds and Thornburg Strategic Income Fund. He is responsible for overseeing the research, trading, and strategic positioning of municipal bond portfolios. He can be reached at gstrickland@thornburg.com.

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