First Quarter 2008 Tax-Exempt Muni Bond Market Review
April 17, 2008
Author(s):
Despite recent headline news regarding the credit problems with monoline insurers, the collapse of the auction-rate market and an economic slowdown, the municipal market offers investments with extremely low default rates. In a recently published report by Standard & Poor’s, the default percentage for investment grade municipal bonds, was less than 1% even 22 years after the bonds were issued. Given these very low default rates, there is ongoing discussion by the House Financial Services committee on modifying the method used to rate municipal bonds. Many states are pressuring rating agencies to move to a global rating scale, as almost all of the states would have a triple-A rated credit if evaluated by the same standards as corporations. These higher ratings would equate to lower financing costs and would reduce the need for issuers to obtain insurance in order to gain a triple-A rating.
The problems with many of the monoline insurers, notably MBIA, FGIC and AMBAC, have created more pressure to move toward this global rating scale. For years, municipal investors relied on bond insurance as an alternative to understanding credit risk. With almost 50% of outstanding municipal debt enhanced with insurance, the negative outlooks of these insurers by the rating agencies have caused the market to reassess the value of insurance. The market has been very volatile as a result of rating downgrades, proposed rescue plans, the entry of Berkshire Hathaway into the monoline insurance business, injections of capital and the potential for further write-downs. As credit conditions worsen, and as the rating agencies replace existing rating models, capital requirements could continue to rise into 2009. While market values have been affected by this negative news, we have assessed each of our holdings and are satisfied that the underlying issuers remain strong.
Along with the problems facing monoline insurers, the market has also had to cope with the collapse of the auction-rate market. The auction rate securities market, which was first introduced in 1988 for municipals, has grown to a $300 billion market. This part of the market has allowed municipalities to borrow at short-term rates while securing long-term funding. Once the auction process began to fail, many municipalities quickly saw their financing costs escalate, while investors were unable to liquidate their positions. A failed auction is not an event of default of the issuer, but occurs when there are insufficient clearing bids to purchase all the shares that current holders wish to sell in an auction. Municipalities have been quick to call variable-rate debt where the cost of financing has doubled or tripled. So far, municipalities have converted about 23% of these securities.
Past performance is no guarantee of future results. Indices are not available for direct investment. This material has been prepared using sources of information generally believed to be reliable. No representations can be made as to its accuracy. Opinions represented are subject to change and should not be considered investment advice nor an offer of securities.
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