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How to mitigate risk in the municipal bond market

Mike Demas

30 Sep 2016

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REUTERS/Denis Balibouse

With political uncertainty on the rise, how can investors protect themselves against future disruptions in municipal bond markets?

In recent months, heightened levels of political uncertainty have crept into the U.S. municipal bond market. These concerns are largely attributed to the increasingly polarized dynamic between governors (the executive branch) and state legislatures and the impact on local governments.

While the disruption has yet to materially impact investment performance, investors are responding by paying closer attention to political environments at the state and local levels.

Learn more about our transparent, accurate and independent municipal bond pricing data

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Political risk

Political risk is a component of the more widely recognized concept of country risk.

The latter reflects a country’s ability and willingness to service its financial obligations, whereas politicial risk is a function of a state or municipality’s willingness, less its ability, to service its debt.

The long-standing gridlock at federal government level has trickled down the political food chain to impact investment and budgetary decisions at the state and local level.

Add to that, there is the natural tension between federal and local issues due to increasing federal mandates and decreasing levels of federal financial resources.

The result is a situation where it’s hard to differentiate between the willingness and ability to make full and timely payment on outstanding debt.

Financial strain

Recent examples include issues in Illinois and, earlier this year, Puerto Rico, with the latter seen as a classic case of the local administration’s unwillingness to pay its debts.

States also vary in terms of their level of involvement in the budgetary affairs of their municipalities. Examples include the bankruptcies of three California municipalities — Orange County (1994), Stockton (2012) and San Bernadino (2012) — with no remedial action by the State of California.

Against this backdrop, politicians are generally becoming more reluctant to raise taxes, even for infrastructure projects, and the growing pension burden continues to put an ever-greater strain on local authorities’ finances.

California Governor Arnold Schwarzenegger (2nd L) joins other governors in looking toward President George W. Bush as he delivers a speech to Republican governors and party supporters at the annual National Governors Association meeting in Washington, February 23, 2004. Bush, whose public approval ratings have slumped to new lows amid a barrage of Democratic attacks, used tonight's speech as a springboard into the political campaign arena, taking on his Democratic challengers and offering his vision of the future. REUTERS/Kevin Lamarque Pictures of the month February 2004 Pictures of the Year 2004 PP04120010 KL/JDP - RTRDGDJ
Photographer: Kevin Lamarque

Unexpected outcomes

Political risk perpetuates a cycle that results in negative outcomes both for investors and the states and municipalities that depend on their funds for infrastructure and service maintenance and improvement.

For municipalities, failure to pass budgets or legislation often delays funding for critical operational and human services.

The lack of financial transparency creates a loss of institutional creditability and ultimate loss of market access to funding. Partisan political agendas prolong inaction and lead to unexpected outcomes.

Based on any or all of these, the marketplace will extract a cost for perceived preventable actions.

Political obstruction or inaction leads to a series of negative outcomes for all parties.

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Complacency warning

The good news is that thus far (with only a few notable exceptions such as Chicago Public Schools) political risk hasn’t hurt absolute investment returns.

In other cases, such as the State of Illinois, the massive decline in tax-exempt rates to new historical lows, as well as overall tightening in credit spreads, has obscured any potential loss from underperforming credits.

Extremely tight supply conditions in municipal bond markets have further served to dampen any negative effect to date.

Investors with foresight still have ample opportunity to re-position their portfolios to mitigate the impact of political risk without giving up much yield.

But that’s no reason for complacency.

In the wider market, there remains a belief that the combination of low interest rates and tight credit spreads will end badly. Investors may suffer a ‘double whammy’ when both rates and spreads start to reverse.

Buyers can afford to be ‘choosier’ when the market is going down and may finally steer clear of tainted credits. But market access may become a real concern for distressed issuers and could become a self-fulfilling credit factor.

A man rubs his eyes as he waits in a line of jobseekers, to attend the Dr. Martin Luther King Jr. career fair held by the New York State department of Labor in New York April 12, 2012. A report on Friday showed the economy created only 120,000 jobs last month, the fewest since October. The unemployment rate fell to a three-year low of 8.2 percent, but largely as people gave up the search for work. REUTERS/Lucas Jackson (UNITED STATES - Tags: BUSINESS EMPLOYMENT) - RTR30NJJ
REUTERS/Lucas Jackson

Vigilance needed

Political risk is not a new phenomenon but there has been a significant increase in the number of high-profile entities impacted by political uncertainty.

As a result, investors need to be more vigilant than ever before in managing their municipal bond portfolios, looking beyond the traditional indicators of value to potential political risk factors that could impact their holdings.

To protect themselves against future disruptions in the municipal bond markets, investors need to be aware of the political factors at play that could affect their holdings, along with the usual pricing required to value portfolios.

Extensive municipal bond pricing data is offered via Thomson Reuters Pricing Service (TRPS) — an independent, global evaluated pricing source covering over 2.6 million fixed-income securities, derivatives and bank loans.

Flexible approach

TRPS municipal bond evaluations cover investment grade, taxable, high yield and distressed issues across a range of bond types.

Our team of professional evaluators employ a credit curve driven attribute model to deliver accurate evaluations for the municipal universe.

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Additional adjustments are made on an issuer and issue basis for the following attributes: bond type, use of proceeds, state of issuance, tax status (tax exempt, taxable, alternative minimum tax), coupon rate and redemption features.

This attribute based approach provides the flexibility to make adjustments from a macro scale to the granularity of a single security.

TRPS supports thousands of investors by providing them with the information they need to manage market transition and political uncertainty.

Learn more about our transparent, accurate and independent municipal bond pricing data

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