The Manhattan Institute for Policy Research Wednesday released a report arguing that higher interest rates on taxable bonds issued by Illinois and California indicate they are more likely than other states to default on their debts.
Municipal market participants said it’s not that simple.
In an issue brief released yesterday, the conservative think tank’s Josh Barro posited that, since yield spreads represent compensation for default risk, the states with the fattest spreads are therefore at the greatest risk of default.
Barro listed yields on 14 states’ taxable Build America Bonds based on recent trades reported through the Municipal Securities Rulemaking Board. Illinois and California “are in a class by themselves,” Barro found, with spreads over Treasuries of 293 and 278 basis points, respectively.
His conclusion: “Spreads for California and Illinois indicate that they are considered to be at far greater risk of default. ...Their well-documented records of fiscal mismanagement have made bondholders particularly nervous that they will fail to pay their debts.”
The depiction of nervous bondholders is curious, considering that it is virtually impossible to find a municipal analyst or portfolio manager predicting either state will default. No state has defaulted since Arkansas, in the Great Depression.
“It’s very little in terms of a true measure of default,” said John Mousseau, a portfolio manager at Cumberland Advisors. “It’s very hard for me to make the leap into pure default risk.”
If the muni market regards the probability of a state default as remote to say the least, why are yields on Illinois and California debt higher than highly rated Utah or Maryland?
Mousseau cited liquidity and headline risk as the drivers of spreads, especially in a municipal bond industry where the taxable and tax-exempt markets are tugging at each other for supply. He pointed out that the New Jersey Turnpike Authority’s BABs have tightened 170 basis points since April 2009, and not because of any improvement in credit quality. California’s spread has widened about 50 basis points since March, and Mousseau said developments on the credit front have, if anything, gotten better for the Golden State since then.
“In general, I think it’s dangerous to assume that spreads show default,” Matt Fabian, managing director at Municipal Market Advisors, said in an e-mail. “Different bonds get purchased for different reasons by different types of buyers. Spreads can show projected liquidity, risk of downgrade, availability of yield, geographic scarcity, term scarcity, etc.”
