It is understandable that municipal bond investors become concerned when they read about California’s budget troubles, or find their insured bonds are no longer highly rated. Yet, despite the adverse developments brought about by the financial crisis, on the basis of credit quality, the municipal bond market remains in an overall strong position.
As we have noted previously, historically, the probability of municipal bond defaults has been extremely low. We believe this remains the case. Although the rating agencies got it wrong in their approach to sub-prime mortgage backed securities, they remain generally credible when it comes to municipal bonds, their traditional bread and butter.
Muni ratings stay strong
All three bond raters continually review their past municipal ratings and the accuracy of those prior assessments, and publish the results. These “rating transition” studies continue to show that in the municipal sector, rating agencies have been close to the mark. Investment grade municipal bonds, rated “BBB-“ or above, have had an exemplary record of paying debt service in full, and on a timely basis. This record has held up during good times and bad.
This track record is even more important when we consider the state of the bond insurance industry. The decision of traditional bond insurers to reach beyond their “core competencies” has cost them dearly. Over the last year, because of poor underwriting of sub-prime mortgages, traditional pillars of strength in the financial guaranty business – MBIA and Ambac – have seen their own ratings plummet, along with those of FGIC, XLCA and CIFG. These insurers, all of which, at one time, were rated “AAA,” have caused the insured ratings of thousands of bond issues to fall along with their own. The massive downgrading of insured bonds accompanying the bond insurer downgrades has given the appearance of a muni credit “meltdown,” when nothing could be further from the truth.
Debt service remains a priority
In fact, as the state of California has just proven, debt service payments are “essential” to the functioning of state and local government and are traditionally treated as one of the highest priority payments a borrower seeks to honor. Similarly, following Hurricane Katrina, the state of Louisiana and its subdivisions met their debt obligations despite the loss of approximately one-third of state budget revenues.
The fact is, the vast majority of credits insured by the former “AAA”-rated insurers were of solid investment grade quality without the insurance. The decision to insure an issue is usually based on whether the reduced interest rate (cost savings) obtained from selling with an “AAA” rating outweighs the insurance premium. As we have noted before, the triple-A insurers rarely insured risky credits and were very successful without doing so.
A side benefit for issuers, but not investors, has been that using a bond insurer’s rating meant an issuer did not have to obtain a public rating themselves. For investors, the lack of an “underlying” rating is often misunderstood as a sign of weakness for an issuer. In fact, underlying ratings are generally obtained in the following circumstances: when an issuer has other non-insured debt outstanding, or when a bond issue is a “story” bond. Story bonds are issued for either complicated or unusual projects to satisfy investors who might be wary of a project type they have not seen before.
Most pay on time, in full
The upshot of all of this is simple. Yes, economic times have been extremely difficult and certainly bond issuers have not been immune. However, long track records established by muni issuers have continued to show that the vast majority of municipal bonds continue to be paid on time and in full.
A side effect of the demise of many old line “AAA” bond insurers is that thousands of insured bonds currently have no ratings, despite their obvious underlying credit quality. Rating agencies have decided to withdraw bond insurer ratings from insured issues when the underlying issuer’s credit quality exceeds that of the insurer.
While some issuers are seeking to reassure investors by applying for ratings post-issuance, many others may not. Despite this turmoil, the municipal bond default rate remains extremely low and we don’t expect that to change anytime soon.