As the municipal market’s sensitivity towards underlying credit grows, particularly in light of the subprime mortgage crisis and its effects on bond insurance, analysts and portfolio managers say they are sharpening their skills more than ever to guard against future unexpected risks.
When it comes to the research, market participants say that in the current market, in-depth qualitative analysis is just as important as — and in some cases more important than — quantitative analysis rooted in statistical and mathematical models.
Participants say credit research has evolved from a routine method of maintaining the overall credit quality and safety of a portfolio to heavily affecting a bond’s pricing and trading values.
With such a vast number of issuers and bonds in the municipal marketplace, analysts said it had been easy for investors in recent years to rely on industry standards, such as rating agencies and gilt-edged bond insurance, when buying or trading tax-exempt securities.
But bond insurance industry problems in the latter part of 2007 has made investors more skeptical to the extent that triple-A rated insured bonds are undergoing more surveillance and pricing pressure than ever before now that there is a bigger push for credit research, analysts and managers say.
“Everyone may have taken too much for granted when it comes to the credit quality of the bond insurers,” said Dan Solender, director of municipal bond management at Lord Abbett & Co. “I don’t think that will ever be viewed the same again. Given the pressures they are under right now, there will be a lot more scrutiny [of insurers] going forward.”
“In the past, we always looked at underlying credits — even if the bond was insured — because we worried about downgrade potential, or overall credit quality,” Solender said. “Now, it’s necessary because the triple-A ratings are not as certain. Insured bonds have a wider trading range and trading value depending on the insurer and the underlying credit quality. With weaker insurers there is closer attention paid to the underlying bonds.”
Overall, the insurance crisis has increased the intrinsic value of credit research and underscores the importance of examining a bond’s underlying credit, according to Richard Ciccarone, chief research officer and managing director at McDonnell Investment Management LLC.
“This recent negative turn related to credit enhancement has validated our long-time approach,” he said, adding that it involved researching underlying credit quality of insured bonds by evaluating debt leverage, liquidity, surpluses, and margins well before the subprime mortgage impact on bond insurance.
Ciccarone said there have been wide swings in investor habits over the years — from ultra-conservative to an over-dependence on insurance.
For instance, prior to the mid-1980s in the early days of bond insurance, conservative investors — mostly clients of trust departments — would only buy bonds from a “working list” of no more than 500 pre-approved credits.
In more recent years, buyers have been able to select bonds from thousands of issuers at any one time, but that sparked a heightened comfort level for bond insurance with little consideration for the importance of the underlying credit, Ciccarone said.
“They have tended to over-rely on insurance companies because the number of credits out there is so vast,” he added.
Mitchell Savader, chief executive officer of the Savader Group LLC, an independent municipal research firm, is seeing those effects as he fields more calls from asset managers and property and casualty insurance companies requesting that his independent municipal research firm examine the underlying credit on some of the insured bonds they own.
“We are getting probably three requests a week from firms we’ve never dealt with before,” Savader said. Asset managers need help in analyzing credits that became part of their portfolio because they relied exclusively on bond insurance without looking at what was underneath it, he said.
One firm recently sent him a list of hundreds of credits that needed to be evaluated on their own merit, and Savader has had to increase his staff to cover the increased demand, he said.
Dick Berry, chief investment officer for the tax-exempt group at AIM Advisors Inc., is one asset manager that has increased his use of the Savader Group recently to provide credit research on some bonds insured by ACA Financial Guaranty Corp.
“We wanted to make sure we could live with the underlying credits. Luckily for us those underlying credits were just fine,” Berry said.
Ciccarone said the need for heightened awareness of credit research is why both quantitative models and qualitative analysis are equally important.
Quantitative models help compliment and expedite the credit research process, while qualitative analysis involves the prudent, in-depth surveillance of criteria such as the strength of the economy in a given area, the impact of competition, legal and security provisions, management of the project, and even local politics.
Herman Charbonneau, senior vice president and manager of public finance at Roosevelt & Cross, said fundamental analysis and quantitative analysis has been part of the overall credit process among institutional investors for years.
At his firm, analysts use ratio and financial analysis models along with traditional research, such as evaluating balance sheet strengths and weaknesses, management, legal structure, debt burden, and security provisions.
Those factors — as well as extensive dialogue with an issuer and its financial adviser — are intrinsic to the due diligence process, he said.
“It would not be very prudent for someone to just rely on the numbers,” he said. “If you don’t take those [factors] into account, you are asking for surprises. You couldn’t have ever forecasted a default or delay in payment just based on the numbers,” he said.
Mathew Kiselak, director and senior portfolio manager at Evergreen Investments, said as a member of the institutional side of the market for over 20 years, he focuses on the importance of underlying ratings, and uses intense credit research to prevent downturn risk in his 11 municipal portfolios and five money market funds that total $17 billion.
“It’s your job to understand your downside risk, do your homework, and buy something on its own merits,” he said. As a result, Kiselak avoided negative price action on insured bonds in his portfolio and only weathered some minor price adjustments when the subprime effects unfolded in the bond insurance industry.
Regardless of those developments, Kiselak typically prefers to minimize his exposure to insured paper and currently holds only about 18% in his Evergreen Municipal Bond Portfolio.
He prefers opportunities to buy triple-B credits that are uninsured but have strong underlying fundamentals.
When he does buy insured paper, Kiselak said, for example, he will buy an insured bond with a strong double-A rating — even though there is little, if any, spread differential between the two — in order to enhance liquidity in some cases, he said.
Others say they are maintaining the same intense focus on credit research and underlying ratings that were in place long before the effects of the sub-prime mortgage crisis.
Jonathan Chirunga, vice president and municipal credit analyst at T. Rowe Price Associates Inc., said his firm’s research-driven strategy promotes increased scrutiny of underlying ratings. In situations when the firm buys an insured bond, he said he is doing so based on the strength of the underlying rating — and not on the availability of the insurance itself.
“We are continuing to make sure that we really understand the credits — whether they are insured or not — just in case there are unforeseen circumstances or there is trouble with one of the insurers,” he said.
The firm’s municipal portfolios currently hold roughly 40% in insured debt, and he expects to maintain that exposure over the near term.
At his firm, analysts evaluate bonds on a wide range of criteria, such as the stability of the job market in a particular area and how that may or may not add to the economic base of a city, as well as whether local residents’ income levels can support potential tax increases in exchange for better services.
Like others, Chirunga said he uses quantitative models to evaluate credits, but cautioned that it is only part of the equation. “Analysts still have to interpret what comes out of the models. It’s just another layer of research we use in helping us make an investment decision,” he said.
Matthew Posner contributed to this story.
