Analysts Eye Market Access Risk

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Municipal credit analysts are spending more time evaluating a risk few used to give much thought to: a municipality's loss of market access for refinancing short-term debt.

The auction-rate securities crisis in 2008 reminded the $2.8 trillion municipal bond market that it is possible for investors to abruptly refuse to lend money.

Most municipal borrowing does not require refinancing. But like ARS, some vehicles — such as bond anticipation notes and variable-rate demand obligations — force municipalities to tap the market multiple times for the same sum of borrowed money.

In light of this need, analysts increasingly recognize the vulnerability of municipalities to a market freeze-out similar to the ARS collapse, and are trying to incorporate that possibility into their analyses.

"It definitely is an increasing risk that analysts need to be more sensitive to," said Howard Cure, director of municipal research at Evercore Wealth Management. "Most of the problems with municipal credits have been episodic. It hasn't been systemic yet, where there is a question about whole groups of credits not having access to the market, but that's the risk you're taking."

The great majority of municipal borrowing over time has been structured so that the issuer pays the same amount in debt service each year over the life of the borrowing. Amortizing debt this way means a municipality can forget about the market after bonds are issued. It simply budgets a level amount each year for debt service over the life of the project.

A significant portion of municipalities' debt profiles are in financing vehicles that require borrowing anew. Analysts see a need to evaluate the possibility of a loss of market access for those vehicles and how long an issuer could survive the loss.

Municipalities have sold $71.6 billion of Bans in the past five years, according to Thomson Reuters.

They sell the notes to raise cash in advance of an anticipated bond sale. Proceeds from the issue are then used to repay the notes.

The hiccup comes if the government loses its ability to sell bonds in order to take out the Bans. The expected source of revenue to repay the notes — bond proceeds — doesn't materialize. In some cases, municipalities are limited in the number of times they can roll over Bans by selling new ones, and an issuer conceivably would have to pay off what it thought would be long-term debt in a short time frame.

Standard & Poor's, Moody's Investors Service and Fitch Ratings all try to incorporate the risk of a loss of market access into the ratings for Bans.

Earlier this week, Standard & Poor's issued a request for comment on methodology for quantifying just how likely it is an issuer of Bans will be unable to tap the bond market to pay off the notes.

Standard & Poor's proposes to rate market-access risk as low, neutral or high. It wants to measure market risk based on four factors: legal authority to refinance Bans, long-term credit ratings, the municipality's compliance with disclosure requirements, and the projected market liquidity of the issuer's debt.

Projected market liquidity is based on factors like market familiarity with the issuer and how frequently it sells debt. Based on the new criteria, the Standard & Poor's ratings for about a third of the roughly 250 Ban issues would be downgraded.

"Market access is really critical," said Richard Ciccarone, director of municipal research at McDonnell Investment Management. "Analysts must be confident that the credit quality of the borrower will be maintained in the period in which the note matures. That would not only be based on an individual assessment of the credit, but also assumes any remote, unexpected risk of the market shutting down, similar to what it did in early 2008."

Loss of market access became a reality for municipalities in February 2008, when the $200 billion auction-rate securities market froze.

ARS were securities that changed hands regularly, perhaps every two weeks, at an auction. While they nominally had long maturities, municipalities were essentially seeking a new investor for their paper at every auction. They sold $185.9 billion of ARS from 2003 to 2007, according to Thomson Reuters.

When bidders disappeared from the auctions — a risk few had contemplated — many municipalities were saddled with double-digit penalty rates.

Gabriel Petek, an analyst with Standard & Poor's, said he wanted to consider the possibility that the Ban market would fall victim to a similar freeze-out. Standard & Poor's released a request for comment on the proposed methodology, and will host a conference call about it on Jan. 6.

Most analysts agree that ascertaining the likelihood of a market freeze-out is not a science. Bigger, more-frequent issuers familiar to the market generally have an easier time selling debt, and many analysts believe credit quality is a primary determinant of market access.

"There's a correlation between better credit and market access," said Natalie Cohen, managing director of municipal securities research at Wells Fargo. She also likes to look at the overall debt profile of an issuer, to see whether too much of its debt matures in the short term.

While the perception of market-access risk may be heightened in munis, it remains far below the rollover risk incurred by sovereign governments.

Most nations take on continuous rollover risk even for their plain-vanilla borrowing. Every penny of the U.S.'s revenue next year will not be enough to repay interest and principal coming due — it will need to borrow to pay off its debts. Canada's debt-service costs would consume 43.4% of its annual revenue, while Spain's would take up 49.1%.

California's and Illinois' debt-service costs next year, meanwhile, make up about 3% of their annual revenue.

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