The municipal bond market is fragmented and lacks an overarching theme as it enters the final quarter of 2011.
Participants at the Municipal Bond Summit, hosted by the Securities Industry and Financial Markets Association, expressed a variety of opinions on the marketplace Tuesday but couldn't find much consensus on where the market is heading.
"We've gone through, over the past 10 years, a tremendous cycle of recovery-recession-recovery-recession, so we're almost back to where we started," said David Stephens, head of municipal products group at Bank of America Merrill Lynch.
Issuers, he added, are now running out of tricks in their tool kit and they want to bring debt loads down.
Stephens said some have suggested the past decade's theme could be "the road to perdition." He's a little more optimistic and dubs it "the road to creative destruction," a reference to Joseph Schumpeter's term for capitalism's aptitude for innovation.
Build America Bonds were a perfect example. Stephens called BABs — the taxable asset backed by the federal government paying 35% of the interest cost — an "incredibly powerful" tool which gave issuers "a wonderful source of capital with very low cost."
BABs expired at the end of last year. During their short reign, they allowed issuers to tap a whole new base of investors and compelled them to become more sensitized to investor relations than to rating agencies.
Indeed, Robert Trippe, chief financial officer at the nonprofit American Municipal Power, a wholesale power supplier for municipal electric systems, said his team spent more time in the last two years doing roadshows to explain what AMP is and how it operates than at any time since its founding in 1971.
The market now lacks an alternative financing mechanism, but Stephens predicted that 2012 issuance might be a return to a more "normal" range of $350 billion. He supported his projection by noting how issuance has ticked up the past month, as have volume projections for the rest of the year.
But Hector Negroni, managing director at Goldman, Sachs & Co., said market participants need to be careful about looking in the rearview mirror as they make projections about the future, given the degree of evolution the last few years.
Leveraged tender-option bond programs, which once owned close to 10% of all muni debt, now play a minimal role. And bond insurers, which once wrapped more than half of all issues, are no longer a major presence.
Fewer natural buyers of tax-exempts are chasing less supply, Negroni said, leading to volatility in price action.
Thankfully, it has been temporary thanks to BABs in 2009 and 2010 and a massive slide in new supply this year. But a permanent solution for the obstacles has yet to be found.
"The problem is the lack of diversity in the marketplace," Negroni said. "Most meaningfully, there's been a big concentration of the buyer base, such that we don't have a lot of diversity of participants. We have a lot of people who are largely expressing the same views and acting in the market at the same time."
Negroni said there is a limited range of ways to express a different opinion. For investors, the muni market is notoriously difficult to hedge — Negroni likes to quip that you can "be long, or less long" — and liquidity providers have few tools at their disposal.
Chris Ryon, portfolio manager at Thornburg Investment Management, said these problems can be aggravated by the fact that up to three-quarters of the market is owned by retail investors if you include direct ownership, mutual funds, and exchange-traded funds.
That's more than double the retail presence of any other market, Ryon said, noting retail ownership of corporate bonds is just 30%.
The result, as seen in the rapid sell-off of late 2010, is a market that can exhibit a herd mentality.
According to Robert Amodeo, head of municipal investments at Western Asset Management, households woke up last year and realized they didn't understand what they owned. They thought they had bought a triple-A balance sheet and treated muni investments as a "set it and forget it" product.
But speculation on widespread muni defaults suddenly became a big item in newspapers, on the radio, and on prime-time television.
So while market challenges are no different than in years past, as issuers must opt for good policies and match revenues to expenses, Amodeo said the landscape is "vastly different" for investors.
"You can't lose sight of fear," added Alan Hart, chief investment officer at Cedar Ridge Partners. "That still permeates this marketplace despite the strides that we've taken post-financial meltdown."
Amodeo suggested that cross-over buyers, including separately managed accounts, would prove to be a stabilizing force as the marketplace attempts to regain its footing.
Despite these myriad concerns, a bird's-eye view suggests the market remains quite healthy.
Defaults have remained rare despite "unprecedented credit stress" in the market and 10 straight quarters of downgrades outnumbering upgrades, according to Bob Kurtter, managing director of public finance at Moody's Investors Service.
Of debt rated by Moody's, there have been just two defaults in 2011, three last year, and one in 2009.
One reason defaults are low is that state and local governments are not facing a debt crisis, but a revenue and spending crisis, Kurtter said.
"By most objective measures, state and local governments are relatively lowly leveraged," Kurtter said. "Their debt, for the most part, is relatively manageable."