Muni Update

Readers have had some questions about municipal bonds lately, so I figured I would provide a quick snapshot of the current market.

Municipal credit spreads, along with everything non-treasury, widened dramatically during the credit crisis. Since then, spreads have recovered from the widest levels but remain wide on a historical basis. The graph below shows credit spreads over Treasurys for A rated GO Municipal Bonds over the last two years.

The 20-year average for this spread is -46 basis points compared to the current spread of +1.2%, meaning that municipal bonds historically have a lower yield than Treasurys.

While munis have struggled to move back to their long-term averages, corporate bond spreads, which also blew out during the credit crisis, have had a much better time recovering to more normalized levels.

So why are they different? The default rate for municipal bonds is historically very low, but the overhang of unfunded pension liabilities has been more of a concern during the recent business cycle. Financial reporting for municipalities is notoriously slow, sometimes lagging the reporting period by more than a year. During a time of heightened concern, lack of financial data will only compound its effect on spreads. Corporate balance sheets however, are in great shape from a credit standpoint. Large liquid asset balances and low debt costs as a result of the corporate bond refi boom in 2010 are easing corporate bond investor’s concerns, and the market is reflecting that.

The most recent muni market noise involves a few notable analysts calling for widespread municipal defaults. Such a scenario isn’t being priced by the market as likely to happen at this point, but a there is no doubt that difficulties in the market aren’t being ignored. The credit crisis saw the end of municipal bond insurance, which the market leaned on significantly for insight into the hard to see financial data of state and local municipalities. The shift away from that model, to maybe one where municipalities provide better data (which would be expensive), or pay a higher rate of interest for financing (maybe even more expensive), might be the way business is done going forward. Until the path is clearer, the market will continue to demand a premium in municipal bonds.

Have a great weekend.