Monday, August 27, 2012

Bond Investors Scoff At Credit Risk

source:  Barron's, August 25, 2012

It was only a couple of years ago that investors were worried by municipal credit worthiness.

Wall Street analyst Meredith Whitney - who famously blew the whistle on the sorry state of the banking system in 2007 - went on the the CBS news program 60 Minutes in December 2010 to warn of impending crisis in the municipal credit markets.

After her appearance, municipal bond prices cratered, as panicked investors dumped their holdings.  Eventually, though, the markets stabilized, and when actual municipal defaults actually declined in 2011 Ms. Whitney's remarks were quickly dismissed.

But the state of municipal finances is still precarious, as last weekend's front page article in Barron's made clear.

The chart above is taken from the Barron's piece.

The most interesting part of the chart is on the states listed in the lower right hand side, on the bottom.

Take for example the state with the highest ratio of debt + pension liability to GDP, Connecticut.

While this is only one measure of credit risk, the fact that the Nutmeg State has a higher level of debt obligations than any other state in the United States would lead one to believe that Connecticut debt should trade at a considerable yield premium to other states.

But, as the chart shows. the demand for tax-free Connecticut paper is such that the state really is not being penalized at all in the secondary market.

Massachusetts, by the way, is not all that much better, as can be seen.

The lack of regard for risk in the bond market stands in stark contrast to the stock market.

The best performing sectors in the stock market over the last 18 months or so have had two characteristics in common:  stable business models and high dividend yields. Thus, utilities; telecom; and consumer staples have been strong relative performers, while the growth sectors of the market have been largely ignored.

In the bond market, meanwhile, the desire for yield has overtaken any concerns about credit quality.

The Financial Times noted last week that sales of junk bonds have reached $220 billion so far in 2012, the second-largest level ever. Only in 2011 - when sales of below-investment grade securities hit $235 billion during the same time period - has issuance reached this lofty level.

Meanwhile, Europe and Asian issuers are also finding a robust appetite for their debt offerings, despite the widely-publicized economic concerns. In Europe, roughly $12 billion in corporate debt has been issued in August compared to an average $8 billion, according to the FT.  In Asia, nearly $41 billion has been issued compared to the historic monthly average of $27 billion.

Demand for municipal debt has followed the same trends as the taxable markets.  Robust demand for municipal bonds has pushed yields to historic low levels.

But when the Oracle of Omaha starts reducing his exposure to municipals, should others take note? Here's what Barron's wrote:

That {municipal debt} strain was brought into sharper focus recently with Berkshire Hathaway's disclosure that it had terminated $8 billion of municipal derivatives contracts. Those contracts were effectively bullish bets on state finances. Berkshire CEO Warren Buffett is bullish no more. The company's $30 billion bond portfolio is light in munis, and Buffett is warning about rising municipal bankruptcies and of the risks of insuring tax-exempt debt. "The stigma probably has been reduced when you get very sizable cities like Stockton and San Bernardino to do it," Buffett told Bloomberg television last month, referring to the bankruptcy of the two California cities. The fiscal pain -- and credit risk -- is more pronounced at the local than state level.