Shut-up, CNBC: Carney on Muni bonds edition

Yesterday, Carney, when discussing risks to the Municipal markets said something I feel is inaccurate and deserves correction.

5. Information Cost is High. Muni issuers are not subject to the same disclosure requirements as corporate borrowers. The market is illiquid so pricing is opaque. The swaps market—the market for tradable credit protection—is thin and unreliable. This means that bond buyers may be taking on risks that they are not aware of. This is a recipe for panic once a triggering event occurs. 

First of all, CDS trading on a LOT of things is very thin. The municipal market is not a monolith, it is composed of thousands of issuers and so, yeah, swaps are probably pretty thin for many issuers. Just like bond and CDS mkts would be thin for most corporate issuers. Second of all, municipal market is dominated by retail, for obvious reasons. Joe Smith looking for safe tax-free bonds isn't exactly your average CDS trader.

Secondly, information is not that hard to come by if you know how to look and are not lazy. Anyone that's lending anyone money should do their homework, or at least pay an adviser or fund manager that has fiduciary duty to do it for them. MSRB is a wonderful resource, including a freely available trade history and, as Bond Girl has pointed out before, MSRB's EMMA allows you to find many issues' official disclosure documents.

Lastly, if you are the kind of investor that doesn't need an adviser or fund manager and is buying large amounts of municipal bonds, you can probably afford a subscription to The Bond Buyer and professional research from the rating agencies (ignore the rating and read the analyst's report).

6. Arbitrage Buying Leads to Bubbles. Much of the demand for muni bonds is not a function of credit analysis or a desire for exposure to the revenue streams of local governments. It is done for a technical, legal reason—to take advantage of the tax-free status of muni bond income. This creates an artificially high demand—a bubble—much like Basel accord capital requirements led banks to overinvest in mortgage bonds.

As Bond Girl wrote a few weeks ago, the last few years have seen some demand destruction, not only from a shift in investor's appetite for municipals relative to other securities, but by the departure of a number of leveraged actors that, through the use of short-term funding schemes created additional demand at the long ends of the curve. We're also seeing that "the muni market is transitioning from an interest rate space to a credit space." I can't go into it here, but you should really read Bond Girl's piece, it is excellently written and informative in a way no newspaper ever will be. But, getting back to my point, tax-free income doesn't necessarily increase demand.

Tax-free yield is attractive and investors are usually willing to take smaller yields for tax-free debt because it is still attractive in a taxable-equivalent basis. However, tax-free yields are only attractive to investors that benefit from preferential tax-treatment, limiting the universe of potential buyers--this is why the BAB program was introduced, to stabilize demand by introducing new participants. In my opinion, the tax-exempt yield of municipals actually hurts demand by restricting the universe of potential buyers. One only needs to look at the disparities between non-taxable TEY and BAB yields earlier in the year to see this at work.

The solution here, in my opinion, is for the federal government to refund issuers directly, like in the BAB program. Investors will receive higher yields that are equivalent on a taxable-equivalent basis and municipalities can offset the additional cost of debt service with refunds from the tax collectors paid for by the tax collected on the new, taxable issues. Otherwise, we risk a market where municipals can actually pay a premium, as they trade not only on their taxable-equivalent basis, but also on any extra risk or liquidity premium required by the restricted universe of buyers, increasing volatility and therefore the cost to issuers.