Thursday, February 20, 2014

Review of The Fundamentals of Municipal Bonds, 5th Edition

Speaking of munis recently, The Fundamentals of Municipal Bonds, 5th Edition is a good primer on them. I was interested in seeing the statistics; how the amount and type of outstanding bonds and issuance has varied over time.

One interesting observation in the book,

"The more politically turbulent [darker social mood] times of the late 1960s and early 1970s had the lowest approval rates [of general obligation bond issues]."
Aha! So general obligation muni issuance is a social mood indicator and we can predict that issuance will dry up when mood darkens.

Another broader realization I had was about the myriad types of municipal bonds. General obligation bonds, where the issuer makes a full recourse promise to repay, used to be the only type of municipal bond. The problem for issuers and the underwriters is that these have to be approved by voters.

So, different types of municipal bonds - e.g. revenue bonds that pledge revenue, or special financing districts - were developed partly as a way to dodge the voter approval requirement. A way of forcing additional debt on unwilling voters. Also a way of issuing shaky debt that is not full recourse.

One other thought - it's kind of strange that there is a market for municipal bond insurance. Why does the insurer earn less than the spread over Treasuries, since it is taking all of the credit risk? Why have this middleman in the transaction at all? There are no corporate bond insurers. It's a fascinating puzzle.

I had two theories. One is that municipal bond investors have basically outsourced their due diligence to the bond insurers. Muni bond investors are largely households or mutual funds operated with thin margins, so outsourcing to a firm with comparative advantage in due diligence works.

The other theory is that the insurers are flimflam operations that operate under the theory that municipal defaults are statistically independent when history shows that they are actually highly correlated - which would mean that the risks are uninsurable like mortgage defaults.

This paper [pdf] explores some other theories. A popular academic explanation is "increased liquidity" for insured municipal bonds. But really, that's just my outsourced due diligence theory.



Nathan said...

I think due diligence is a significant factor, though who knows if the risk is being properly priced. The bond insurers also serve as a more sophisticated and motivated party to any bankruptcy proceedings, like what's happening in Detroit now.

Actually, it's quite amusing that Detroit is trying to talk down the value of "full faith and credit" of GO bonds now. Some info on the insurer's counterargument is here. Based on the proposed recovery rates to various parties, it looks like there's still a wide gap between the two sides.

Nathan said...

Oops, that last link is wrong. Here's the correct story about the recovery rates.

CP said...

Thanks. Did you read that paper about the bond insurance puzzle? It had good explanation of the theories.

Are you following the Detroit case? How are the bondholders going to do?