The following are notes from Wednesday’s municipal bond conference call with PIMCO’s Joseph Narens (thanks to Nathan Dutzmann, one of QES’s analysts, for listening in).
We will follow up with some timing considerations Friday.
1. The Big Picture: “Is the Bumpy Ride Over in Municipal Bonds?”
What happened this fall:
Yields are up about 100 bps on munis.
- Started with Treasury yield increase (caused initially by Treasury sell-off).
- Declining values led to declining fund NAVs led to redemptions led to further declines…
Federal “Build America” bond (BAB) program was not extended.
- Program offered muni subsidies
- Stream of negative media headlines created a terrible impression of the muni market.
Munis are a credit market and no longer just a pure rates market.
Each muni credit is unique: state vs. local vs. water vs. power vs. university vs. …
Conclusion: In PIMCO’s view, likely level of muni defaults is below what market prices imply.
- Popular view of muni debt crisis is overblown
- Total muni debt / GDP ratios and debt service / revenue ratios are not unsustainably high in aggregate, though individual issues may be at risk.
- One risk point: Variable rate demand obligations (VRDOs) represent some roll-over rate risk, but not systemically significant.
- VRDOs are about 10% of all munis and about ¼ of VRDOs are set to expire/roll-over this year.
State deficit projections (and thus default risk) are overstated.
- States rarely rely on deficit financing; 49 states (all but VT) have balanced budget amendments.
- Future spending projections do not account for constitutionally required cuts.
- Budget proposals in many major states (Calif., Texas, N.Y., Ill.) are addressing the problem for future years as well as this year.
At the local level, on the other hand, defaults should become more common. Reasons:
- Less state aid (see above).
- Ongoing housing crisis leads to lower property tax revenues.
- Less liquidity/higher spreads in local munis.
Significant long-term risk: Unfunded pensions
- Unfunded pension liability estimates range from $700 billion to $3 trillion, depending on discounting methods.
- In some states, full depletion could lead to “pay-as-you-go” costs of up to 40% of state budgets within the next decade…Obviously not sustainable.
2. Municipal Bond Fund Outlook
PIMCO has had huge outflows from muni funds of late, but insurers and other large players are moving in.
Even some non-tax-exempt “cross-overs” like hedge funds are moving into the space because muni spreads are so high.
PIMCO is not expecting a muni supply spike, for two main reasons:
- Much of the debt issued in favorable circumstances last year was intended to fund projects this year.
- Many projects will be canceled because of high interest rates.
Because of near-term risk, PIMCO has shortened duration in its muni funds (a "safe spread” in Bill Gross’s terminology.) Still, PIMCO considers the risk of default, even in troubled states, to be low – much lower than is currently priced into the market. (“Safe spread” per Bill Gross’s terminology.) Still, PIMCO considers the risk of default, even in troubled states, to be low – much lower than is currently priced into the market.
3. The Rest of the Story
Even balanced-budget states can have projected “deficits” because of intra-cycle changes to revenues. Deficits are forecasted in the absence of fiscal adjustments.
A federal proposal to allow bankruptcies by states caught the markets by surprise, but it probably has no traction.
Individual muni issues cannot be shorted by law, but CDS can be used as a hedge. Nonetheless, PIMCO is not concerned about the possibility of hedge funds “ganging up” against muni bonds.
PIMCO does not hedge within muni funds. Risk is managed through bottoms-up credit analysis and shortening of duration.
Risk points for individual cities:
- Secular decline (e.g.,Detroit)
- Poor financial engineering (e.g., Jefferson County, Ala,)
- Funding for non-viable projects (e.g., Harrisburg, Penn.).
Read more from Ben Warwick on municipal bonds: