Supply, Demand, and Default in Muni Land

Conclusion: We are sticking to our call that a supply/demand imbalance will drive up muni bond yields as the year progresses. In addition, we believe a structural elevation of credit risk will continue to get priced into this market over the long-term TAIL.


Position: Short muni bonds (MUB).


It’s would be a severe understatement to say that the State of Illinois’ finances are in rough shape. Consider the following metrics when analyzing this Domestic Pig: 

  • Debt/Revenue: 141.3% vs. the national average of 90.2%;
  • Interest Coverage Ratio: 13.6x vs. the national average of 32.4x; and
  • FY12 Budget Shortfall as a % of FY11 Budget: 44.9% vs. the national average of 15.5%. 

After years of fiscal mismanagement and spending growth that has consistently outpaced income growth, the State of Illinois now finds itself sitting on top of 208,635 unpaid bills totaling $4.52B, which itself sits on top of an additional $3.8B in additional unpaid liabilities including withheld corporate tax refunds and skipped employee health insurance payments. Including these obligations, which current governor Pat Quinn proposes issuing $8.75B in debt to fund, Illinois’ Debt/Revenue figure jumps +2,064bps to 161.9%.


In addition to Piling Debt Upon Debt (Illinois was the second-largest municipal borrower in 2010), the State has already signed off on raising its corporate and individual income tax rates by +46% and +67%, respectively. With a three-factor model of aggressive debt buildup, tax hikes, and routinely skipping payments to vendors, municipalities, and nonprofit organizations, there’s no surprise the Illinois electorate disapproves of Governor Quinn’s performance by a factor of 2-to-1.


From an investment perspective, none of this is new-news, which is why Illinois CDS (5Y) continues to trend down, closing yesterday at 193bps from a peak of 358bps in early January. Over the intermediate-term TREND, we agree with the credit market’s conclusion here, as it is highly unlikely that the State of Illinois defaults on any of its debenture obligations within this window of time. Over the long-term TAIL, however, we expect the State’s mounting debt burden, pension funding requirements (a national-low 51% funded), and healthcare liabilities (0.1% funded) to become too much to bear (source: Pew Center on the States). One important lesson the credit market taught us about itself is that it doesn’t know what it doesn’t know – Lehman CDS (5Y) was trading at ~300bps mere days before it went belly-up. 


Supply, Demand, and Default in Muni Land - 1


Supply, Demand, and Default in Muni Land - 2


Illinois will, however, continue to default on many of its other obligations as it is currently doing, which will increase the amount of debt the State is likely to issue in the coming months. While Illinois may be the dog of dogs in this regard, a widening gap between hard-to-cut expenditures (see: WI, OH, IN budget debates) and consistently overestimated revenues on a national level will cause aggregate muni bond supply to accelerate quite substantially in the coming quarters, up from a record-low amount in the first quarter ($43.2B in total fixed rate issuance).


Supply, Demand, and Default in Muni Land - 3


On the revenue side specifically, a recent study done by the Pew Center on the States shows that States typically aggressively overestimate revenues coming out of recessions, meaning that State budget deficits are likely to surprise to the upside as the fiscal year progresses, especially given that their revenues have been bolstered by now-dwindling Federal aid over the past two years. Net-net, the results of national fiscal austerity being cheered on by muni bond fund managers as a reason to buy muni bonds right here and now could wind up looking like the recent upwardly-revised debt and deficit projections for Greece and Spain. If you didn’t know sovereigns could “miss” estimates, now you know. Lower revenues = more mid-year muni bond supply.


Supply, Demand, and Default in Muni Land - 4


On the demand side of the equation, hedge fund buying amid a relative lack of supply has supported the muni bond market in recent months – something we don’t see continuing. In 4Q10, Federal Reserve Flow of Funds data showed that “Households” (a category that includes domestic hedge funds and other investor pools) increased their investments in muni bonds by +$50B, amid a (-$18B) decline in Mutual Fund muni bond assets (retail investors). In addition, a slowdown in the rate of defaults was positive from a headline risk perspective (removes the “Whitney factor”); according to Distress Debt Securities Newsletter, nine muni bond defaults totaling $445M occurred in the 1Q11, down from 22 and $1B in 1Q10.


We question whether the hedgie crossover buyers that were gobbling up “mis-priced” muni bonds at the start of the year truly understand the potential supply/demand mis-match that looms on the horizon for this market. In 4Q11, “attractive yield spreads” relative to “historic averages” weren’t even enough to entice new sources of demand to absorb the market’s (albeit elevated) supply - +$50B in new hedge fund/“other” demand vs. +$86B in new supply (new issuance + mutual fund selling). We also question whether their revenue assumptions are accurate, given that GDP is likely to continue to coming in light over the coming quarters, which will effectively keep a lid on State tax receipts in FY12 – a call we’ve been making for several months.


All told, we are sticking to our call that a supply/demand imbalance will drive up muni bond yields as the year progresses. In addition, we believe a structural elevation of credit risk will continue to get priced into this market over the long-term TAIL. For a deeper dive into this thesis, refer to our February presentation titled, “Mayhem in Muni Land”.


Darius Dale


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