From the October 2009 issue of Investment Advisor • Subscribe!

Not Quite So Risky Business

An exploration of credit risk and pricing in the muni market

One of the investment advisor's major tasks is to help manage risk for clients, but if your clients are invested in municipal bonds, you'd better brush up on how the recession has affected the pricing of those bonds. From my vantage point as a portfolio manager for a muni bond fund, I know that the municipal market has undergone several significant changes in the last two years. Moreover, our research suggests that the municipal bond investor is being well compensated right now in taking on additional credit risk. So let's explore that proposition.

First, understand that there are several methods an advisor can use to assess the market's pricing of credit risk, i.e., the risk of non-payment of principal and interest due to default. This is important because the market, with its collective reasoning, will sometimes charge too little for credit risk and, at other times, too much. The market's predisposition toward mispricing credit risk is highly correlated to its sense of euphoria or fear.

Credit Risk Measure #1: Credit Quality Spreads

The first method of measuring the market's pricing of credit risk is to look at the level of credit quality spreads, that is, the incremental yield the market pays to entice an investor to purchase securities of lower credit quality. Take a look at Figure 1 (below), which illustrates the yield increments the market is paying an investor to buy BBB-rated municipal revenue bonds versus AAA general obligation municipal bonds. Currently, an investor is being paid just about 3.00% more income to own a lower-investment-grade municipal revenue bond over an AAA GO municipal bond. So is there ample compensation in this recessionary environment for the extra credit risk? We would argue that investors are being well compensated to take on extra credit risk.

Consider the major changes in the municipal market over the last two years. For instance, all municipal bond insurers have lost their Aaa/AAA ratings. Berkshire Hathaway, the newest entrant to the municipal bond insurance business, is now rated AA2/AAA. This is significant because in recent years close to 50% of the new issuance of municipal bonds came to market as insured. To reflect this change in the market we recalibrated our data as of January 2007 in an effort to capture current market conditions. The Credit Quality Spreads chart shows that, in terms of statistical measures, the current spreads of 3.00% are 1.68 standard deviations from the mean of 1.67%. In plain English, only about 10% of all observations lie outside this range. If we were to use the old method of calibration (not taking into account the changes in the market) we would be at a 5.49 standard deviation event, which happens between 0.000057330% and 0.000000197% (this is not a misprint) of the time.

Credit Risk Measure #2: Implied Default Rates

Another way to measure the market's pricing of credit risk is to examine the implied default probabilities reflected in current market prices and compare them against the market's actual history. To calculate these probabilities we compared the pricing of various securities, all within the investment grade category AAA-BBB of the municipal market, against credit-risk-free securities (pre-refunded bonds). These securities all had maturities of 10 years. To do this calculation we also had to assume a recovery rate on the municipal securities--the percentage of a bond's principal that is recovered after the default. We have run the calculation assuming both 40% and 60% recovery rates (see Figures 2 and 3).

In a November 24, 2008, Merrill Lynch note, recovery rates for municipal bond defaults were quoted between 100% and 40%, depending on the type of security. Those securities that were in the higher risk categories and dependent on a single revenue stream posted the lower recovery rates. These recovery rates were calculated by Fitch.

The two charts show the results of these calculations for the last four months. These results are compared to the historic default rate of the investment grade category of the municipal market (0.13%).

So at a conservative 40% recovery rate (municipal defaults typically have a higher recovery rate), the market is pricing a 19% probability of default. This seems quite high when compared to the cumulative default rates for the period January 1, 1986, through January 1, 2009, (calculated by S&P in March 2009) of 0.13% for the investment grade segment of the municipal bond market. Have municipal bond default rates ever approached these levels? The answer is yes.

For instance, a 2004 article by reports that a study conducted in 1988 by Enhance Reinsurance Co. that looked at historical patterns of municipal defaults from the l800s to the 1980s concluded that municipal defaults usually follow downswings in business cycles and are also more likely to occur in high-growth areas that borrow heavily. "Following the 1873 Depression," according to the article, "Municipal Bonds and Defaults," when more than 24% of the outstanding municipal debt was in default, the greatest number of defaults occurred in the South, the fastest-growing region at the time. Factors that caused defaults included fluctuating regional land values, commodity booms and busts, cost overruns and financial mismanagement, unrealistic projections of the future, and private-purpose borrowing." That same source reports that "since World War II, revenue bonds have been a new source of default, largely a result of revenue over projections."

Wall Street Journal reporter Liam Denning argued in a March 12, 2009, article that a study by Professor George Hempel of Washington University (Municipal Bonds: State of the Tax Exempt Market) found the default rate on muni bonds across the period of 1929--37 was 16.2% of outstanding debt. The estimated loss rate, however, was a mere 0.5%. Furthermore, Denning points out that bondholders involved in the Orange County, California, default of 1994--the largest ever--"recovered 100% of principal and interest."

What to Do?

The current levels of credit quality spreads are very wide and translate into implied default probabilities that are multiples of the historic 10-year default rate (0.09%). You have to go back to the period between 1929 and 1937 to find a historic default rate that nears those implied in current price levels (16.2%). Even in that time period, actual losses were much less.

That is why we believe that the municipal bond investor is being well compensated in taking on additional credit risk. However, credit risk must be actively managed, and that's what you should expect from any municipal bond management team in building its muni bond portfolios.

Christopher Ryon, CFA, is a managing director for Thornburg Investment Management with over 23 years of investment management experience. He is a co-portfolio manager of the Thornburg Strategic Municipal Income Fund. He can be reached at
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