With U.S. tax receipts down 19%, income tax collections down 28%, and sales tax revenues down 11% on a year-over-year basis as of June 30, 2009, according to a September 2009 newsletter from Breckinridge Capital Advisors, Inc., many investors are worried about the fiscal health of municipal issuers at the state and local levels.
Most states are now facing 2009-2010 budget deficits, since roughly 90% of each state's revenues are derived from income and sales taxes, while local municipalities primarily receive revenues from property taxes. Many states such as Michigan, California, New York and New Jersey are experiencing torrents of negative press due to fundamental weakening of their economies and fiscal situations, which has sparked fears of municipal bond downgrades and defaults.
Institutional asset managers in the municipal bond market are navigating this environment in a number of ways. Most have underweighted state General Obligation bonds of states with the direst fiscal conditions, in favor of states with healthier economies and more stable tax revenues (think of Texas, for example). In addition, many managers are focusing on local General Obligation bonds where the underlying demographics and tax base remain strong. Another area of interest for investors has been in Essential Service Revenue bonds (water, sewer, and electric), where the issuer typically has a de facto monopoly and the flexibility to raise rates to meet debt payments, if needed. Lastly, while investment managers are generally underweighting higher-risk states (California, Nevada, Florida, New York and Michigan come to mind), in those instances when new issues are priced at significant spreads to the rest of the market, they have been buying and in large amounts.
Between 2002 and 2007, roughly 50% of new municipal bond issuance came to market with insurance from AMBAC, FGIC, MBIA and other insurers, according to a report, "Municipal Market Update 2009," from Fidelity Investments. The number of issuers purchasing insurance quickly declined in 2008 amid the monoline insurance debacle and subsequent downgrading of the monoline companies' credit ratings. In fact, in 2007 there were seven insurers rated AAA by the three major rating agencies. Today none of the insurers are AAA-rated by all three major rating agencies (Moody's, Standard & Poor's and Fitch). Further, in 2009, less than 15% of new bonds have been insured, according to the Fidelity report.
The dramatic fallout in the insured municipal bond universe led to insured bonds trading on their underlying ratings, resulting in wide spread credit migration from AAA quality to AA, A and BBB ratings. Individual investors representing roughly half of the market, and many institutions, have long relied on the credit rating agencies and insurance-enhanced credits to build their municipal bond portfolios. Now, with the evaporation of the insurance industry and the growing distrust in the rating agencies, many investors have been exposed to greater credit risk than they had previously anticipated or experienced. In some instances, insured municipal bonds have traded at discounts to the exact same bond without insurance, which highlights the extreme headline risks and dislocations that have occurred in the municipal market over the last 24 months.
