DOCSLIB.ORG

BOND MARKET PERSPECTIVES Major News and Themes Driving Fixed Income Markets

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
BOND MARKET PERSPECTIVES Major News and Themes Driving Fixed Income Markets BOND MARKET PERSPECTIVES Major News and Themes Driving Fixed Income Markets August 2012 Bond Market Perspectives | Week of August 27, 2012 LPL Research Marketing 75 State Street Highlights Boston, MA 02108 800-775-4575 We view Berkshire Hathaway's sale of municipal credit derivatives simply as the closing out of a [email protected] profitable trade, and not a true concern for broad-based municipal credit quality. www.lpl.com Washington, not credit related issues, may pose the greatest near-term risk for municipal bond investors. Municipal Misconceptions Renowned investor Warren Buffett recently made headlines when his firm Berkshire Hathaway disclosed selling $8 billion worth of municipal derivatives contracts during the second quarter of this year. The news lingered in financial markets and over the weekend of August 25-26, 2012. It was cited by a widely-followed financial news source as a misleading intro to a story on state credit quality. Several media sources have construed the sale as yet another sign of deteriorating state credit quality. We caution against reading into stories suggesting a sharp deterioration in municipal credit quality. We simply view the Berkshire Hathaway sale for what it is-the closing out of a profitable trade. We believe Berkshire would have likely sold the entire position, rather than just half, if there was true concern for broad-based municipal credit quality. If Berkshire did have a negative view of the municipal bond market, it could have easily placed a bearish bet but did not. Buffett and Berkshire Hathaway declined to comment to reporters on the motive for the trade but we believe Berkshire simply found a more attractive investment on a go-forward basis. The cost to insure against municipal default has declined since the financial crisis when Berkshire Hathaway initiated the trades. Since peaking at 3.5%, the cost to insure a basket of municipal bonds against default has declined by roughly half and a 0.5% decline in the premium over the first quarter of 2012 may have been the catalyst for the sale [Figure 1]. Lower Credit Default Swaps (CDS) mean a lower premium, and therefore less profit, to insure against default. Berkshire's sale may be similar to Berkshire's municipal bond insurance unit, Berkshire Hathaway Assurance Corp (BHAC), ceasing to insure new municipal bond issuance. The downfall of several municipal bond insurers in 2008 and beyond created an opportunity for well capitalized firms like Berkshire willing to step up and provide insurance in the marketplace. Strong demand for insured municipal debt, during a time of heightened credit fears, meant muni bond insurers could charge more for their services. As the market moved on from insurance the cost to obtain insurance declined, making it less profitable for insurers like BHAC. Federal Reserve (Fed) Researchers Take a Shot This August the New York Fed, through its Liberty Street Economics blog, released its own study of municipal defaults indicating that municipal defaults are greater than what was implied by long-term default studies conducted by Moody's and Standard and Poor's rating agencies. The Fed study claimed that defaults were much greater than reported by Moody's or S&P since both failed to account for non-rated bonds, but this is hardly news. Non-rated, more speculative bonds have historically been the biggest source of defaults in the municipal market and that remains true today. Of the approximately $13 billion in municipal defaults over the last three years, roughly $10 billion originated from non-rated issuers, according to Municipal Market Advisors (MMA) and Municipal Securities Rulemaking Board (MSRB) data. In general, the news on municipal bond defaults continues to improve. Through the end of July 2012, $820 million in municipal bonds have defaulted year-to-date, versus $1.34 billion over the same period in 2011 according to MMA and MSRB data. The fact that defaults are on pace to decline for the fourth consecutive year is an impressive achievement for municipal issuers and speaks to the priority of debt payments and resilience of the municipal bond market. The municipal market largely ignored recent news headlines and outperformed Treasuries so far this August as indicated by improving valuations relative to Treasuries [Figure 2]. A lower yield ratio implies a higher valuation due to lower yield relative to Treasuries. Conversely, a higher yield ratio implies a lower valuation due to a higher yield relative to Treasuries. Washington, Not Pensions, Is the Greatest Near-term Risk Budgets and related pension funding will be a challenge for many municipal bond issuers for years to come. However, investors can navigate around such issues as there are many sectors in the municipal bond market, backed by dedicated revenue streams, that are unaffected by budget or pension issues. We view budget and pension issues as more negative for economic growth than a major default risk would be. We believe the greatest near-term risk for municipals may come from Washington and potential tax legislation, not budgets or pension-related issues. Both presidential candidates have different ideas for tax rates. President Obama seeks to raise tax rates, which by itself would increase the attractiveness of tax-exempt municipals, but may also seek to cap the tax-exemption for top earners. Governor Romney, on the other hand, may seek to lower tax rates, which would reduce the value of the municipal tax exemption. The potential tax implications, if any, could take several forms and the uncertainty could weigh on the municipal bond market. On a positive note, top-rated municipal yields exceed comparable Treasury yields (as Figure 2illustrates) indicating an attractive valuation and suggesting the market is partially braced for tax uncertainty. Sale of Insurance via Credit Default Swaps (CDS) Berkshire's municipal derivatives exposure consisted of the sale of insurance via municipal credit default swaps (CDS), which essentially charge a percentage to insure a principal amount against default. Berkshire captured the premium in exchange for offering to pay against default. As a hypothetical example, a 5-year CDS spread of 3% means it costs $30,000 annually to insure $1,000,000 worth of municipal bonds against default over a 5-year horizon. The premium can rise or fall over the life of the CDS depending on numerous factors, including market perceptions of default expectations and credit quality. IMPORTANT DISCLOSURES The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. A Credit Default Swap (CDS) is designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply. Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate. Treasuries: A marketable, fixed-interest U.S. government debt security. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level. Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value. Credit Quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio's credit worthiness, or risk of default. Default Rate is the interest rate charged to a borrower when payments on a revolving line of credit are overdue. This higher rate is applied to outstanding balances in arrears in addition to the regular interest charges for the debt. Non-rated bonds have not been issued a rating by bond rating agencies such as Standard and Poors and Moodys. Bonds that have not been rated by an agency are usually considered to be junk bonds or fall below investment grade. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Derivatives involve additional risks including interest rate risk, credit risk, the risk of improper valuation and the risk of non-correlation to the relevant instruments they are designed to hedge or to closely track. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. LPL Research is a Registered Representative with and Securities are offered through LPL Financial, member FINRA/SIPC.
Load more

Recommended publications
  • The Price of Safety: the Evolution of Municipal Bond Insurance Value
    Hutchins Center Working Paper #5 2 A u g u s t 2 0 1 9 The Price of Safety: The Evolution of Municipal Bond Insurance Value Kimberly Cornaggia John Hund Giang Nguyen Smeal College of Business Terry College of Business Smeal College of Business Pennsylvania State University University of Georgia Pennsylvania State University A BSTRACT We examine the benefits of bond insurance to taxpayers using comprehensive data and selection models to control for fundamentals and the endogenous choice to insure. Prior to 2008, insurance provided Aaa coverage and saved issuers 9 bps on average. Insurers were then downgraded in 2008–2009 and municipalities upgraded due to Moody’s scale recalibration in 2010, shrinking the difference in credit ratings between the underlying issuers and the insurers from both sides and lowering the value of available credit enhancement. Overall, insurance provides gross value when insurers have higher ratings than the issuers they cover. Only relatively low- rated issuers benefit, subsidized by higher-rated municipalities who over-insure. Cross-sectional results indicate that agency problems and conflicts of interest play a role in issuers’ decisions to over-insure. A version of paper was presented at the 8th Municipal Finance Conference at The Brookings Institution on July 15-16, 2019. The Internet Appendix to this paper is available at https://www.dropbox.com/s/og4ocqlg1yua6a7/YieldPaper_InternetAppendix_20190719.pdf?dl=0. The authors thank Ryan Israelsen and Marc Joffe for comprehensive historical municipal bond ratings, and Zihan Ye for geographic mapping data. They thank Dan Bergstresser, Daniel Garrett, Mattia Landoni, Scott Richbourg, Mike Stanton, Anjan Thakor, and audience members at the Federal Reserve Board, Penn State University, the 2019 SFS Cavalcade, Texas Christian University, the U.S.
    [Show full text]
  • Bond Insurance: Introducing a Better Business Model
    Bond Insurance: Introducing a Better Business Model Mark Adelson and George H. Butcher III* Today’s bond insurance industry has lost the ability to create value for the great major- ity of municipal bond issuers. Despite an environment of wide credit spreads, the weak- ened state of the active bond insurers has virtually eliminated their ability to improve pricing for issuers at or above the single-A credit grade. The underlying problem is that the bond insurers and the credit rating agencies embrace a business model for the sector that presumes an ability to accumulate resources in the future, after the onset of stress. The presumption causes the bond insurers to hold too few existing resources in relation to their insured risks and undercuts both their credit quality and the pricing effect of their guarantees. The solution is an alternative business model that entails a much higher level of existing claims-paying resources in relation to the insured risks. Contingent capital securities provide a cost-effective vehicle for accumulating such resources. Combined with certain operating rules and continuous quantitative testing of credit quality, the new business model can create a truly strong, stable, and transparent bond insurer. oday’s bond insurance industry struggles to maintain a presence in the municipal bond market. According to conventional wisdom, Tthe use of bond insurance has declined because municipal credit spreads are narrow. However, the conventional wisdom confl icts with the facts. Although absolute yields have been low for a long time, munic- ipal credit spreads have been consistently wider in the years following the fi nancial crisis than in the years preceding it.
    [Show full text]
  • Primer on Municipal Bonds Primer
    Primer on Municipal Bonds Primer Municipals | United States 22 June 2015 Primer on Municipal Bonds Philip Fischer Municipal Research Strategist MLPF&S The basics of municipal bonds We discuss the basics of municipal bonds: how the market began, the composition Martin Mauro of the market, the different kinds of short-term instruments, the size of the market, Fixed Income Strategist MLPF&S the changing nature of bond insurance and the importance of the tax treatment of municipal bonds. Ian Rogow Municipal Research Strategist MLPF&S Celena Chan Municipal Research Strategist MLPF&S Sophie Yan Municipal Research Strategist MLPF&S Source: Getty Images. BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 22 to 24. 11507463 Primer on Municipal Bonds 22 June 2015 Contents Highlights 3 Historical perspective 4 Features of a Municipal Bond 5 Overview of the Market 7 Bonds: Maturities of more than 13 months 7 Notes: Maturities of less than 13 Months 8 Industry segments 9 Build America Bonds 11 High Yield Municipals 11 Munis by the numbers 12 Tax categories 14 Municipal bond ratings 15 Bond insurance 17 The tax-exempt appeal of munis 18 Tax-free income 18 Alternative Minimum Tax (AMT) 18 Par, Premium, and Market Discount Bonds 19 2 Primer on Municipal Bonds 22 June 2015 Highlights A municipal bond is a loan made to a unit of state or local government.
    [Show full text]
  • Financial Guarantors and the 2007-2009 Credit Crisis Working
    Financial guarantors and the 2007-2009 credit crisis Daniel Bergstresser Randolph Cohen Siddharth Shenai Working Paper 11-051 Copyright © 2010 by Daniel Bergstresser, Randolph Cohen, and Siddharth Shenai Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Financial guarantors and the 2007-2009 credit crisis Daniel Bergstresser* Randolph Cohen** Siddharth Shenai*** (First version January 2010, this version November 2010. Comments welcome.) Abstract More than half of the municipal bonds issued between 1995 and 2009 were sold with bond insurance. During the credit crisis the perceived credit quality of the financial guarantors fell, and yields on insured bonds exceeded yields on equivalent uninsured issues. It does not appear that either property and casualty insurers or open-end municipal mutual funds were dumping insured bonds; analysis of holdings data indicates that their propensity to sell bonds was unusually low for the issues insured by troubled insurers. At least on a bond-by-bond basis, the yield inversion phenomenon is also not explained by the rapid liquidation of Tender Option Bond (TOB) programs, which disproportionately held insured issues. Finally, during the recent crisis the insured bonds have become significantly less liquid than uninsured municipal debt. Keywords: Bond insurance, municipal securities, credit crisis. We are grateful for comments from John Chalmers, Otgontsetseg Erhemjamts, Michael Goldstein, Robin Greenwood, Jens Hilscher, Ryan Taliaferro, and from seminar participants at Babson University, Bentley University, Brandeis University, and participants in the HBS research brownbag lunch.
    [Show full text]
  • Muni Insurer Update
    M UNICIPAL MUNICIPAL UPDATE CREDIT MUNICIPAL INSURER UPDATE JANNEY FIXED INCOME STRATEGY AUG 19 2009 MUNICIPALS: INSURER UPDATE Nearly two years after concerns about triple-A municipal insurers first emerged, only four bond insurance companies with investment grade ratings remain. They are: Assured Guaranty Corp. (Assured), Berkshire Hathaway Assurance Corp. (BHAC), Financial Security Assurance (FSA) and National Public Finance Guarantee Corp (NPFG), formerly MBIA. The below chart includes a list of all of the ratings and outlooks for companies who insure(d) municipal issues. Monoline Insurer Credit Ratings >Only four monoline bond insurers have managed to mantain investment grade credit ratings amid losses on structured finance insurance products. Source: Janney FI Strategy; Moody’s; S&P; Fitch Over the past two years it became apparent that the so called monoline insurers were in fact not monoline. The insurers were backing not only municipal market credits, but had ventured into TOM KOZLIK the business of insuring riskier structured products backed by residential mortgages. As the Municipal Credit Analyst value of the residential housing market fell, so did the value of the structured products. These 215.665.4422 losses led to record claims on the insurance companies who insured them. As a result, the municipal bond insurance business, although still considered valuable by investors, is a business [email protected] currently under a tremendous about of review by the rating agencies. The rating agencies have continued to question the viability of the municipal insurance business, especially as volumes have declined. Recently, the trend has been for municipal insurance companies to return to See page 4 for details their roots and keep their municipal businesses separate from the other riskier businesses.
    [Show full text]
  • Title Insurance and the Bursting of the Real Estate Bubble
    View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by DigitalCommons@Pace Pace Law Review Volume 30 Issue 1 Fall 2009 Real Property, Mortgages, and the Economy: A Article 18 Call for Ethics and Reforms September 2009 Can't Live Without Air: Title Insurance and the Bursting of the Real Estate Bubble Marvin N. Bagwell Bagwell & Associates Title Agency LLC Follow this and additional works at: https://digitalcommons.pace.edu/plr Part of the Banking and Finance Law Commons, and the Property Law and Real Estate Commons Recommended Citation Marvin N. Bagwell, Can't Live Without Air: Title Insurance and the Bursting of the Real Estate Bubble, 30 Pace L. Rev. 180 (2009) Available at: https://digitalcommons.pace.edu/plr/vol30/iss1/18 This Article is brought to you for free and open access by the School of Law at DigitalCommons@Pace. It has been accepted for inclusion in Pace Law Review by an authorized administrator of DigitalCommons@Pace. For more information, please contact [email protected]. UNSETTLING MORTGAGE LAW: IMPLICATIONS FOR PRACTITIONERS AND TITLE INSURERS &DQ·W/LYH:LWKRXW$LU Title Insurance and the Bursting of the Real Estate Bubble Marvin N. Bagwell* ´&DQ·WOLYHFDQ·WEUHDWKHZLWKQRDLUµ1 I. Prologue A few months ago, I wrote a brief article originally titled ´A Fairy Tale,µ which ended up being published in The Bulletin, The Journal of the New York State Land Title Association³a title industry publication. Several people who read the article prior to its publication advised me against releasing it to the public.
    [Show full text]
  • Municipal Bond Policy Writing Business Update and Comprehensive Table of Credit Ratings
    Municipal Bond Policy Writing Business Update and Comprehensive Table of Credit Ratings Below you will find three things 1) an excerpt from the Municipal Bond Weekly that discusses an article from Bloomberg Brief concerning municipal bond insurers business, 2) a comprehensive table of municipal bond insurers with their ratings and 3) the Bloomberg Brief article itself; “ Insurers Build Most Market Share Since 2009 ”. You can find the most recent Moody’s reports on: 1) Assured Guaranty subsidiaries (AGM, AGC and MAC) by typing the ticker “ AGO ” (link ) (the parent of these subsidiaries) into BairdWeb, 2) National Public Guarantee Corp . by typing in the ticker “MBI ” (link ) (MBIA is the parent of NPFGC) into BairdWeb and 3) Radian by typing in the ticker “RDN ” (link ). For the other rated insurers, 4) There is no Moody’s research available on BairdWeb because either the entities are not- rated/withdrawn ratings (ACA, Ambac, CIFG, FGIC, XLCA) or are not Moody’s rated (BAM). Bond Insurers Building Books of Business – From a recent Bloomberg Brief article it was highlighted that municipal bond insurers are now building books of business. So far in 2014, insurers have insured 5.2% of the $248 billion of new issuance (the highest in over five years). In 2013 3.2% of issuance was insured. Before the financial crisis approximately 50% of issuance was insured. It has become obvious, as was expected, that insurance has provided value to investors; Detroit is a case in point and Puerto Rico may become so. In the case of certain Puerto Rico bonds at the nadir of prices during the summer the difference between insured values (approx.
    [Show full text]