The pension crisis and the muni bond market

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The Pension Crisis and the Muni Bond Market

June 25, 2017 by Robert Huebscher

Underfunded pension plans grab the headlines. But that's not what drives prices in the municipal bond market, according to Tom Doe. It's the interplay between supply and demand ? and right now yields are depressed due to a shortage of highquality bonds.

"It's all about investing the massive amount of money coming into this sector," Doe said. He added that this is the biggest supply shortage since the fall of 2013.

Doe is the founder and chief executive officer of Concord, MA-based Municipal Market Analytics (MMA), an independent research firm that provides strategic market and credit research on the U.S. municipal market and industry. I spoke to him on June 23.

Yields on municipal bonds are still attractive, though, for taxable investors. The taxableequivalent yields on 10-year and 30-year municipal bonds are considerably higher than comparable maturity Treasury bonds.

Doe recounted the pension problems facing several key states. But he said that, even in

those states, individual investors who hold high-quality bonds to maturity should be confident they will receive all interest and principal payments.

Tom Doe

Let's look at what Doe said about conditions in the muni market and the implications for investors who hold bonds in pension-plagued states.

Why taxable investors should own munis

On a nominal basis, 10-year AAA-rated munis yield 10 basis points less than equivalent maturity Treasury bonds and the spread on 30-year bonds is only 12 basis points. Those spreads are wider than earlier this year. On a taxable equivalent basis, though, Doe said that 10- and 30-year munis trade 100 and 200 basis points above Treasury bonds, respectively. Doe said those spreads are "appropriate" and reflect the greater credit risk in muni market.

Spreads for the two- and five-year maturities are at the same levels as before the financial crisis, while the 10- and 30-year spreads are wider, Doe said.

According to Doe, yields are a function of supply and demand and for munis demand is driven by the Baby Boomer generation's preference for fixed-income investments. By 2020, 70% of that cohort will be 65 years and older.

There is also an international demand for short-term muni bonds. Does said that due to a change in regulation in the fourth quarter of last year, insurance companies in Asia now own approximately $120 billion in munis.

In a curious move, Doe said that some significant high-net worth non-U.S. investors are positioning themselves in anticipation of Trump's proposed $1 trillion infrastructure program. To enhance their lobbying efforts, he said they bought bonds to "reflect their commitment to infrastructure projects."

But Trump's infrastructure will have a "benign" effect on the muni market, Doe said. Some privately-funded projects might expand issuance, he claimed, but stadium financings might contract, offsetting one another.

There hasn't been a pickup in muni issuance this year. June is typically the biggest issuance month, he said, but it is on track to be 13% below the 10-year average, consistent with the pattern this year. Doe had expected 2017 issuance to be more than $400 billion, but he now projects $360 billion.

"That is generating an amplified valuation of municipal yields," he said, "driving them down."

Refundings might increase supply as they did in 2016, Doe said, but that component of supply won't be anywhere near

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where it was in last two years.

"The demand for muni product has continued to drive investors down the ratings spectrum and further out the yield curve," Doe said.

A key issue is whether the federal government will preserve the tax-exempt status of muni bonds. Doe said there is "nothing on the table" that would remove that status, but he said the muni industry is too complacent. Gary Cohn, Trump's chief economic advisor, is not in favor of the tax-exempt status of munis, Doe said. Others higher up in the administration are divided, he said, and some favor public-private partnerships as an alternative to the tax-exempt status.

"If tax reform moves forward," Doe said, "the exemption is still at risk but that is a low probability."

Should investors worry about the pension crisis?

The muni market has been largely oblivious to the travails of states that are struggling with underfunded pension plans. Indeed, Doe said that Fitch's recent move to lower the rate it uses for discounting pension-fund liabilities to 6% was a "nonevent" in the market.

Money continues to flow into ETFs, mutual funds and separately managed accounts, he said. "The long-term issues don't have an impact," Doe said. "Anything that could happen in less than five years is absolutely disregarded by the industry."

Since fund managers get paid by their assets under management, they won't say "no" to money and continue to invest and downplay the long-term credit problems, Doe said.

"At the state level default risk is very, very low," he said, "as it is for some major cities."

But there will be ratings downgrades and headline risk. Those investors' holdings will suffer high volatility and loss of market value, according to Doe. "If they need liquidity, they may find that they won't get a price close to the evaluation that was on their statement."

"Those are the risks investors face," he said, "more so than default."

The big states with problems are led by Illinois, where its 10-year AAA-rated bonds trade at 300 basis points above the Treasury curve. If funding dries up at the state level, it trickles down to the cities and towns, he said. Doe said that some educational institutions are facing default because the state has stopped funding them, like the Chicago Board of Education. But, he said he was surprised when O'Hare airport came to the market and its bonds had strong demand.

"It comes down to the state leadership and its willingness to uphold bond obligations and the tradeoff between pension holder and bondholder," Doe said

Doe said that investors who need liquidity should stay away from Connecticut, where bonds trade at a spread of 95 basis points. GE and Aetna have left and Florida and other states are wooing Connecticut's business. Southern Connecticut has one of the softest real estate markets, particularly among homes priced at $2 million and up. Connecticut has a "leadership issue with a challenging economic landscape," Doe said.

In New Jersey, spreads are only 116 basis points over Treasury bonds, which Doe said is "absolutely absurd." But the demand for those bonds keeps those yields low, according to Doe. Prior to 2013, most state-specific mutual funds had 50% of their holdings in Puerto Rico. They reduced their Puerto Rican exposure and bought state-specific bonds instead.

"It's a real problem when funds are not smart about what they own," Doe said.

There are no easy fixes to pension underfunding. The city of Houston followed Maryland in adopting a "cost-corridor rule," where pension contributions are adjusted to keep the plan at a pre-determined funding level. For such a plan to work the state or city must maintain its contributions. "But history has shown that is not a reasonable assumption to make," Doe said. Houston is also supposed to issue pension-obligation bonds, which Doe said was a "fool's errand."

How realistic is it for advisors to evaluate individual muni bonds?

There are two things to consider, Doe said.

For all the headline risk, the defaults and credit "impairments" (a material credit problem) are very, very low, according to Doe. He said the pace of default this year, excluding Puerto Rico, has been slower than the last two years, as has been the

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number of impairments. "But investors should take impairment very seriously," Doe said. "It is very hard for advisors and investors to track that." Doe's bigger concern is liquidity. He said muni prices are extraordinarily high ? about 3% overvalued because of the supply-demand imbalance. "But that can and will change at some point," he said. Bondholders may intend to hold to maturity, he said, but rarely do. "When they go sell they may get a price far below what is on their statement." That problem is amplified by the way in which muni bonds are priced. Only 1% of the market trades daily, and the pricing services use a "matrix" (algorithmic) approach to determine the pricing of the other 99%. Shrewd fund managers can selectively buy or sell the benchmark securities that drive the prices in the rest of the market, effectively distorting the pricing to increase the value of their products. As a result, ETFs and funds provide better liquidity and value for exiting, Doe said. "Buy-and-hold investors will get the cash flows they are promised," he said. But the important thing is that "life events happen" and cash will be needed prior to when a bond matures. "The expectation of holding to maturity is rarely met," said Doe.

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