Phil Fischer, head of municipal research at Bank of America Merrill Lynch in New York, has a simple suggestion for investors who want to avoid the next Detroit: Look at the ratings.
Michigan’s biggest city, which filed a record municipal bankruptcy on July 18, had a junk grade since January 2009 from Moody’s Investors Service.
Fischer, 66, who assumed his current role in June, discussed the $3.7 trillion muni market for today’s Bloomberg Brief: Municipal Market newsletter.
Q: What value does Bank of America (BAC:US) place on ratings?
A: As a research group, we do credit research and strategy, and we try to have a balance. Credit in the muni market is basically bifurcated by rated and unrated bonds.
Because of that, if you want to avoid most of the credit issues in the muni market, it’s an extremely easy thing to do. There aren’t very many credit surprises. All you have to do is buy rated bonds and then watch the ratings. And if the ratings start to trend adversely, then ask yourself whether or not that bond is something you still want to hold. That appears to clearly be working for us.
Q: How does Detroit’s bankruptcy get resolved?
A: Chapter 9 is an area of the bankruptcy law which has not had enough legal developments. Hopefully, the Detroit litigation will clarify the role pensions have in Chapter 9 proceedings, and of course the role unsecured general-obligation bonds have. Those two items particularly need to be clarified so the market can properly assess the relative value of those bonds.
Q: Was it always a mistake for general-obligation bondholders to think they would get top priority if a local government fell into distress?
A: It’s a complicated legal issue and there are elements that need to be worked out. If, in fact, the decision is returned adversely to general-obligation bondholders, the issuers of general-obligation bonds should think about redesigning them to give them more security.
Q: Are we going to see an increase in Chapter 9 filings?
A: There’s not much to indicate any great surge in the area. Moody’s just upgraded states to stable, the revenues seem to be coming in quite solidly and the budgets are balanced.
Detroit was very much its own particular economic scenario. It has had a long-term cycle of economic issues. Michigan thought for this particular city, the most rational thing to do was to let a bankruptcy court resolve the various competing issues. We see it in the market as its own unique circumstance.
Q: Muni bonds are experiencing the worst losses since 1999, driven by persistent withdrawals from mutual funds. Is the market behaving like it usually does -- outflows lead to sales which lead to price declines which lead to more outflows which lead to more sales -- or is this time different?
A: We know that in this market we set up an unfortunate cycle of that occurring. The market’s behavior will turn around when we see a general level of rates and expectations of rates turn around. Munis now -- especially long-term munis -- are cheap, and for many investors would be a very attractive place.
Investors, especially individual investors, chase returns. So when returns are good, they put money into the funds and invest until the returns turn poor. And once they turn poor, they start selling.
Q: Do you think there will be proposals that will threaten the muni-bond tax exemption? If so, what will they look like?
A: The Treasury’s interest in reducing the tax exemption is very long-term. The difference between now and earlier this year is state and local governments have stepped up and affirmatively acted to defend the tax exemption. They need to continue to do that. That has taken the momentum away from discussions about removing the tax exemption. But it will never really go away.
We don’t know what would replace it. You can’t just make all these bonds taxable, because the price to state and local governments would be very high. Congress or the Treasury might suggest one of their favorite remedies, which is a tax credit bond, but we’ve seen that they trade very poorly.
Q: Will there be a bond-insurance rebound, given that yields are up and Detroit is proving the value of the backing?
A: The insurers are probably going to find more demand for their product. But returning to 50 or 60 percent of the market being insured is very difficult to see.
The headline discussions of unique credits are likely to make some individual investors want some more support. As a market we’re not seeing any fundamental shift in credit. If anything, the credits in the muni sector are getting stronger.
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