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VIEWS: “The Decade in Review” by Triet Nguyen
DPC DATA takes a look at how the fundamental changes in Municipal Market structure drove the need for improved trade and credit data
Welcome to 2020 and the start of a brand-new decade. Instead of going through the normal laundry list of market-shaping events, we thought it might be interesting to look back at all the fundamental changes in the structure of the municipal market over the past decade and correlate them with what we perceive as the rising demand for better-quality trade and credit data, on the part of both buy-side and sell-side market participants.
As market participants returned to work in January 2010, the municipal market was just beginning its recovery from the seismic shocks of the Financial Crisis and Great Recession of 2008. The Financial Crisis dramatically changed the public finance sector. It ushered in what Tom Kozlik at Hilltop Securities rightly calls “The Most Eventful Decade Ever for Municipals.”
And what a decade it turned out to be. At the most fundamental level, the Financial Crisis led to the de-commoditization of the municipal market. This largely resulted from the demise of many of the bond insurers and other financial guarantors.
Insurers’ credit rating as proxy
Up until about 2007, the tax-exempt market had been riding the ever-increasing penetration rate of the bond insurers. This peaked at about 60 percent by 2006. Aside from the risk-seeking investors in the relatively small high yield sector, most market players were content to let the insurers become their proxies for credit analysis.
And why not? Staffed with large research departments, insurers such as AMBAC and MBIA (now known as National Public Finance Guarantee Corp.) were more than happy to engage in their version of credit arbitrage in exchange for lending out their “AAA” rating. Most bonds traded based on the insurer’s rating, thus creating a relatively homogeneous, commoditized market.
Nothing short of a statistical “tail event” would have disrupted that happy scenario, and unfortunately, that’s exactly what happened.
Although a couple of the insurers have managed to survive, and indeed thrive, since the crash (e.g., Assured Guaranty, alongside post-crisis new entrant, Build America Mutual), the financial guaranty blow-up all but ensured that most investors would never again rely solely on the insurers’ credit assessment. In fact, all institutional investors now insist they always assess the underlying credits regardless of the insurance wrap.
The bond insurance sector has since become a mere shadow of its former self, with a market penetration rate of only about 6 percent. This is despite having proven its value to investors again and again in credit situations such as Puerto Rico (more on this later).
Public pension woes
The Great Recession blew a big hole in the assets of most of the nation’s public employee retirement systems. Moreover it exposed the woefully under-funded status of many of them. While the unfunded public pension liabilities issue is not exactly new (analysts have been flagging this potential problem as far back as the 1990s), what used to be a slow-moving train wreck has now become the front and center credit issue in muniland.
This problem has in fact become even more intractable, as the rights of public sector pensioners have often been upheld by bankruptcy judges over those of bondholders. In some states, most notably in Illinois, pension benefits are even protected by the state constitution, effectively making them untouchable. Most distressing is the fact that many public retirement plans have yet to improve their funding status. This is despite the strong performance of the financial markets over the past decade.
One of the key reasons for this persistent funding shortfall is that many plans still use unrealistically high expected rates of return to discount their liabilities. In fact, many pension experts believe the municipal practice of using the expected rate of return as the discount rate for the liabilities is basically unsound. (Such a discount rate should be something along the line of a high-grade corporate yield index.) No wonder there is widespread concern that most public pension funds will not be able to withstand the next stock market correction, when (not if) it occurs.
A rising pension burden may also lead to a potential “crowding out” of essential services, as state and local officials struggle to prioritize current operating needs versus legacy obligations. The City of Chicago is currently going through such a process, with no easy solution in sight.
Bankruptcy and debt crisis
Away from the pension issue, the two most significant credit events of the past decade were the 2013 Detroit bankruptcy and the Puerto Rico debt crisis, which ostensibly started in 2012 and continues to this day.
In a nutshell, the Detroit bankruptcy opened the door for experts in corporate bankruptcy to exploit the lack of legal precedent in the municipal Chapter 9 process and severely undermine the Full Faith & Credit General Obligation (G.O.) pledge, the gold standard of municipal security. Literally overnight, the G.O. FF&C pledge went from the top of a municipality’s capital stack to the bottom. It’s now viewed just as a “senior unsecured” obligation, absent a statutory lien on specific revenue sources.
This startling turn of events took many market participants by surprise. Many responded by flocking to revenue bonds over GO ULT bonds. But, once again, the rug was pulled from under them as the revenue bond sector came under attack from an unlikely source: the judge presiding over the quasi-bankruptcy proceedings for Puerto Rico and its agencies.
In her controversial ruling from the Assured/Puerto Rico Highway Revenue Bonds case, Judge Laura Swain appeared to undermine the exemption from the stay in bankruptcy for revenue bond issues, to the dismay of many Chapter 9 experts. As our friends from Kroll Bond Rating Agency (KBRA) have repeatedly pointed out, this decision also affected the legal status of most dedicated revenue pledges.
For now, the market is finding some solace in the fact that only the automatic stay may be in jeopardy, not the actual revenue pledge itself. Nevertheless, investors are now keenly aware of the importance of having an actual statutory lien on any pledged revenue and not relying on any vague full faith and credit pledge.
New credit risk factors
As the decade drew to a close, new credit risk factors have caught the attention of muni investors: cybersecurity and climate change.
Cybersecurity risks had certainly been around for a while. However, the last two years of the decade saw an explosion of cyber threats, particularly to healthcare institutions, who can ill afford any service interruption or leakage of confidential patient information. Cyber attacks also graduated from the smaller, more vulnerable towns to major cities such as New Orleans.
Up until recently, the municipal market has been able to shrug off severe climate events, particularly the annual hurricane season in the South, since any potential credit impact would be “federalized” through federal disaster relief. That’s no longer the case. There is growing recognition that climate change is an intermediate-to-long term risk factor. It needs to be dealt with immediately by state and local officials. Current market technicals notwithstanding, sooner or later the market will come around to penalizing issuers who lack a climate action plan.
Rise of ESG
In contrast to climate change, which is viewed as a defensive risk management issue, the rise of ESG (Environmental, Social & Governance) investing should be a positive growth area for the municipal asset class as it repositions itself as the ESG investment of choice.
Impact on municipal data
So how did all these developments feed the rising demand for improved municipal data? The de-commoditization of the market means that each municipal credit, from the largest mega-issuer to the smallest bank-qualified issuer, now must be analyzed on its own merits.
Traditional credit data providers, most attached to proprietary platforms, have been content to cover primarily the larger issues for their institutional clients. This leaves a large coverage gap when it comes to smaller, infrequent issuers.
Money managers, who now claim to be looking at every underlying credit regardless of insurance, are struggling to find an adequate data source which allows them to monitor the hundreds, if not thousands, of muni obligors in their portfolios. Ideally, credit databases now have to be organized in such a way as to facilitate a review of the entire capital structure of any municipal obligor, down to the CUSIP level.
In this context, it’s hard to overstate the need for a logical and consistent mapping of individual securities to the correct obligors and correct sector classifications.
Credit risk as the consistent standard
Most credit analysts realize they need to have the ability to roll up credit exposures into credit clusters or to identify the correct security pledge for their holdings. We would argue this is where most legacy data sources fall short: by using inconsistent standards for sector classification, sometimes based on the issuer, sometimes based on the revenue pledge, and at other times based on the use of proceeds, etc.
At least for analysis, trading, and risk management purposes, the one consistent standard should always be “credit risk.” This assumes, of course, that the ultimate source of credit risk is correctly identified.
Away from traditional risk factors, the rise of ESG investment themes should further stoke the need for alternative data sources, particularly data related to the potential regional impact of climate change, such as sea level rise, etc.
Technical changes to the market
On top of the dramatic shift in credit fundamentals, the decade of the 2010s also saw the municipal market go through a series of changes which are more technical in nature.
First, the relative shift away from actively managed bond funds to Separately Managed Accounts (SMA) and Exchange-Traded Funds (ETF) should significantly bolster the demand for easily consumable fundamental credit data.
According to Tradeweb Direct, “muni separate accounts now boast a whopping $600 Bn in assets, three times the amount held in 2010 (…) After 46 consecutive weeks of inflows, muni funds now hold $739 Bn, more than double their holdings in 2010”. Unlike their bond fund competition, SMA managers usually lack access to a large credit staff and have to contend with a multiplicity of small issuer holdings. One can only imagine the credit surveillance nightmare that would ensue.
More passive investment vehicles such as Exchange-Traded Funds (ETF) have also exploded in popularity. As of yearend 2019, muni ETFs totaled $48.69 Bn in assets, spread across 58 funds, according to J.R. Rieger of The Rieger Report. Given their low nominal fees, one would expect ETF managers to be constantly on the lookout for ways to improve operational efficiency.
Need for better reference data
For many of the reasons mentioned above, dealer trading desks could also use a better set of reference data. Along with a dynamic data-based reference curve, accurate bidding requires coming up with an accurate set of trade “comparables.” This is a process which still requires too much manual intervention due to the shortcomings of legacy databases.
A more accurate mapping scheme of securities to obligors and specific sectors would go a long way toward enabling automated bidding on retail blocks, thus freeing up traders to cater to their (hopefully) more profitable institutional business.
Having access to better data would further allow dealers to extract more cost savings from their current operations, given the current environment of declining bid-ask spread, shrinking inventory, and ongoing sell side consolidation.
Algorithmic trading and AI
On the subject of automated trading, one of the more interesting developments in recent years has been the advent of algorithmic trading shops such as Maritime Capital and Headlands Capital. Although their trading models currently rely primarily on trade data, it’s certainly only a matter of time before they venture into credit trading.
The search for better data could also begin at the point of origination, as evidenced by the current push toward financial reporting using machine-readable formats such as XBRL. The jury is still out, however, about whether state and local issuers can be incentivized to adopt this new reporting protocol, given their deep-seated suspicion about the potential cost of another unfunded federal or state mandate.
Last but not least, we all know the technology buzzwords for the next decade, arguably a bit over-hyped, is “Machine Learning/ Artificial Intelligence”. Yet, any AI application, however ingenious, cannot succeed without the proper foundation of clean, granular data. At the end of the day, to paraphrase a familiar political slogan, “It’s All About The Data, Stupid!”
New decade, evolved data requirements
While we don’t pretend to have “20/20” foresight (pun fully intended), it does appear that, after years of lagging other markets in terms of technology adoption, the municipal market now stands at the threshold of a new age of data transparency and technological innovations. We at DPC DATA certainly hope so and we intend to be a very active participant in this exciting new environment.
Disclaimer: The opinions reflected in this article are solely the author’s. They do not necessarily represent the official position of DPC DATA, Inc.
“Views” from DPC DATA is a new feature we’re adding to our website. We’ll be featuring periodic insights on significant market events, as well as interesting research results from our compliance and disclosure efforts.