A Tale of Two Decades in the Municipal Market
The birth of the google.com domain name and Microsoft's Internet Explorer 4.0 software in September 1997 set in motion a two-decade transformation.
Municipal veterans, asked to reflect on the past 20 years, cited the growth of online technology that took off in the latter half of the 1990s as a major contributor to changes in their market that ranged from lower interest rates and tighter spreads between munis and Treasury securities to increased regulation and greater investor sensitivity to credit risk.
Having information "at your fingertips," was the first notable change, according to Bond Buyer contributing editor John Hallacy, a 39-year veteran of the municipal bond market who was a managing director at Bank of America Merrill Lynch in 1997.
The updating of traditional resources such as the Standard & Poor's Blue List, a manual directory of municipal and corporate secondary offerings, had a positive effect, Hallacy said.
"It was like day and night," he said.
"I remember automated retail trading became a real feature – you could do a bid-asked on the system and a trader wouldn't have to get involved."
Richard Ciccarone, president and chief executive officer of Merritt Research Services in Chicago, recalled that technology was "just getting off the ground" in the late 1990s in terms of grasping the municipal market.
Investors relied on rating agencies for underlying credit research, as there were both fewer analysts devoting time to municipal credit research and less technology to aid the effort, he said.
The city of Pittsburgh, Pa., was one of the first to use the internet in November, 1997, when it sold a $70 million competitive general obligation sale via MuniAuction, a website designed to allow issuers to sell bonds in a real-time anonymous bidding environment. Though Pittsburgh's use of the internet was met with some skepticism at the time, it led to a growing trend that has only increased two decades later. Many firms transitioned to e-business as the industry adapted to the internet age through the use of electronic trading, automated exchanges, and alternative trading platforms, municipal veterans said. Those developments provided advantages such as: cost-efficiency for staffing and communications; the elimination of physical constraints on municipal trading and operations, such as geography; direct customer contact with clients; and software technology that made it easier to categorize and match bonds with clients' portfolio needs.
Twenty Years, More than 200 Basis Points
The past 20 years have produced what municipal professionals call an astounding drop in generic triple-A yields and a trend toward continuing improvement in spreads relative to Treasury bonds .
On March 3, 1997, the 30-year triple-A general obligation bond ended at 5.55%, according to Municipal Market Data. It ended at 3.18% 20 years later.
Two decades ago, higher yields led to wider spreads – and more of a differentiation between higher and lower quality bonds, veterans said.
"In 1997, you still had some spread in the market," recalled John Mousseau, director of fixed income at Cumberland Advisors who has more than 30 years experience in the investment management industry, including municipals. He recalled that long Treasuries were yielding 6.50% to 7% and comparable municipals hovered between 5.75% and 6%.
"Yields were higher and there was lots of volatility," he said, comparing a 30-year muni yielding 6% at par with a duration of 13.5 years to today's 3.50% yield at par with a duration of 18.5 years.
Although volume has increased, he said, there is a less compelling buying opportunity with spreads on long paper having compressed about 30% -- in addition to approximately 40% less yield and nearly 40% more risk.
"Today, you have two percent handles on Treasuries and three percent handles on munis -- with little spread," Mousseau said.
Hallacy remembers the spread between the former triple-B-plus rated New York City GO bonds and the generic triple-A GO scale being as high as 150 basis points. Today, the spread on NYC GOs – which are now rated Aa2 by Moody's Investors Service and AA by Standard & Poor's – has compressed to about 35 basis points, he said.
Sectors, like health care and development, also traded at much wider spreads 20 years ago, and high-yield muni deals were noticeably cheaper than the plain-vanilla market, according to Hallacy.
"Rates and credit spreads were much higher in 1996 versus today, although the steepness of the curve is about the same," said Peter Block, managing director at Ramirez & Co. "On a relative value basis, ratios were tighter in 1996 versus today, meaning munis were more expensive versus Treasuries, reflecting the much smaller muni market at the time."
The ratio of 30-year municipals to Treasuries was calculated at 81.3% as of Mar. 3, 1997, compared with 108.2% as of Nov. 30, 2016, according to MMD. Ratios rose in the latter half of 2016 amid expectations of rising rates, the 2016 presidential campaign, and a swift and severe sell off following the unexpected election win of Donald Trump.
In addition to higher yields and spreads, veterans said the tax-exempt market was previously more homogenized, thanks to the prevalence of bond insurance. It was characterized by heavy investor demand – largely for individual bonds – low default risk and little need for concern over credit quality.
Market Technicals and Growth
Rates on the Bond Buyer indexes remained in the 5% range from 1997 through the end of the decade, Ciccarone noted.
"With Greenspan and the Fed there was a long period of tightening that we had to deal with," Hallacy said, speaking of the former Federal Reserve chairman Alan Greenspan who served from 1987 to 2006.
In April 1997, Greenspan raised the fed funds rate from 5.31% to 5.50%. However, much of the tightening under his tenure occurred between 2004 and 2006 and consisted of mostly steady and predictable 25 basis point movements.
At the same time, municipal volume -- particularly refunding supply – was much lower, but growing, Hallacy said.
Since then, the municipal market has grown substantially – especially with the proliferation of refunding supply during frequent periods of gradually lower interest rates.
Long-term annual bond sales have more than doubled in that time – from $220.67 billion among 12,651 issues in all of 1997 to $444.79 billion among 13,274 issues for all of 2016, according to data from Thomson Reuters.
In addition, municipal to Treasury ratios were well under 100%, Hallacy added. "We didn't hit the speed bump until before 9/11 – then, of course, 9/11 changed everything for a while," he recalled.
Credit Quality Ruled
One of the biggest changes has been in credit quality – and the growing emphasis on underlying ratings after the financial crisis of 2007-2008 crippled the claims-paying ability of triple-A monoline bond insurers.
That and the prominent defaults of large cities in recent years made credit quality a more critical concern than in the two prior decades, Jeff MacDonald, director of fixed income strategies at Fiduciary Trust, said in a recent interview.
"Twenty years ago, the GO pledge was the gold standard of municipal credit – it was absolutely sacred in terms of an issuers' access to the market and creditworthiness," he said.
That all changed with high-profile defaults and bankruptcies, such as Orange County, Calif., back in 1994, Jefferson County, Ala.'s November 2011 bankruptcy filing, and Detroit's $18 billion Chapter 9 filing in July 2013.
"We certainly had an evolution of how reliable that GO pledge was," said MacDonald, who has 24 years of experience in the fixed-income and municipal markets.
"Stability was still the hallmark for a lot of people, and Orange County was a wake-up call," Hallacy agreed. "We all knew the muni defaults on one hand – there weren't that many – except for small utility districts in the Midwest."
While there were some flight to quality issues, there were not nearly as many as today, according to Ciccarone, who began his career in 1977 at the former municipal underwriter Harris Bank.
Today, credit risk – particularly at the GO level – has increased and unfunded pension liabilities have added a new element of risk that didn't exist before, MacDonald said.
In addition, the decline in the once-heavy penetration of triple-A bond insurance – which peaked at 57% of all municipal issuance in 2005 – is a structural change that isn't likely to reverse itself, MacDonald said.
"The higher cost of borrowing for issuers at the time was one key reason why bond insurance really took off and subsequently became more prevalent," Block of Ramirez said.
As of 2016, bond insured penetration by the three active insurers – dipped to 5.63% from 6.36% in 2015.
Assured Guaranty, Build America Mutual and National Public Finance Guarantee totaled $25.34 billion of par amount insured throughout 1,889 transactions, both up from $25.29 billion and 1,886 deals in 2015, according to Thomson Reuters.
There is now a higher premium on credit quality as investors can no longer rely on the historical creditworthiness of the market and are more conscious of potential for default – an event that was "unheard of" 20 years ago, according to MacDonald.
"With what happened since the financial crisis, investors no longer view the market as bullet proof in terms of credit and realize there can be problems," he said.
Retail Dominated the Market
Retail investor behavior is similar to 20 years ago in that they are still searching for yield, through they previously favored the "coupon de jour" when 5% and nearly 6% coupons were available and in high demand, Hallacy said. "Every time you got to one of the whole numbers it was a magic number," he recalled.
The municipal market two decades ago was largely driven by mom and pop retail investors and, while they are still a large component of the buy side community, that ownership structure has evolved with the expansion of mutual funds and exchange-traded funds, MacDonald noted.
In 2011, for instance, households held $1.8 trillion in municipal debt, a figure that fell to$1.53 trillion by 2014 , as exchange-traded funds increased their ownership of municipal debt from $8.6 billion in 2011 to $14.6 billion in 2014, according to Federal Reserve data.
"Virtually all smaller regional firms have either merged or have been bought out in an industry that has for more than a decade seen such consolidation," said Mark Tenenhaus, director of research at RSW Investments. "Tightening spreads and severe competition in asset management at a time when low cost ETFs and Index funds are rapidly gaining market share are changing the environment."
Ciccarone noted that individual purchases of municipal bonds are no longer at the high point they were 20 years ago. Experts said the need for professional money management increased with growing concerns over credit risk.
In addition, since the financial crisis, there has been a consolidation of the largest broker-dealer firms that once provided liquidity support to the retail market, veteran players said.
"Firms that were 260 people nationwide in a number of locations are now 60 people with one or two locations," Mousseau said.
The consolidation meant less liquidity, and more reliance on the smaller regional brokers dealers for retail support, MacDonald said.
"While the market became larger in absolute size, the broker-dealer side of the industry actually contracted," observed Sam A. Ramirez, president and chief executive officer of Ramirez & Co., a company he started in 1971. "Not only do we have fewer players, we have more information and efficient technology," he said. "The net result is that we have all become more sophisticated."
Post financial crisis, new products and programs made their way into the municipal market, such as Build America Bonds, which were introduced in 2009 and expired in Dec. 2010 and provided a federal subsidy to state and local governments equal to 35% of the taxable borrowing costs.
"The government stepped in and put some of these programs in place to provide that shock absorber for the financial system to provide credit for the broader market – which failed, froze, and was on life support," MacDonald said.
Retail order periods, which debuted in the mid-1990s, are still a useful and productive component of today's market that were created in the late 1990s, Hallacy noted. They were first used by New York City on GO offerings to give New York retail investors priority amid heavy institutional demand.
Meanwhile, technological advancements as well as increased price transparency and disclosure over two decades has helped enhance the overall operation of the municipal market and bring it into the 21st century, veterans said.
MacDonald said being mandated by the Municipal Securities Rulemaking Board to report real-time trades within 15 minutes has enhanced price transparency significantly compared to when he began his career as a portfolio analyst in 1997 at Wellington Management Co. in Boston.
The SEC rule 15c2-12, which was introduced in 1990 and promotes continuing disclosure, is still enforced today, even though it has seen many amendments.
"The dawn of 15c2-12 added a new secondary disclosure regiment, and that changed things a lot for the better," Hallacy said.
It was followed in 2008 by the establishment of an Electronic Municipal Market Access ("EMMA") system and through amendments to Rule 15c2-12, EMMA became the sole repository for continuing disclosure filings.
While many of the decades-old topics are still evolving in today's market, it is currently facing additional new challenges, such as the proposed tax reform as well as funding for a $1 trillion infrastructure improvement plan under the Trump administration.
While there is much uncertainty regarding new proposals, like other new initiatives in the past, the municipal market will eventually find its way and learn to adapt, Hallacy said in a March 1 commentary in The Bond Buyer about embracing a changing market.
"It's amazing how far we have come," Ramirez added.