The lack of consistency when comparing municipal credit security features and trading value can create opportunities and risks for municipal investors.
Municipal yields today vary greatly, even in the same market sector, and do not always reflect the issuer's credit rating. As a result, more and more investors are purchasing insured securities to ensure credit stability and greater marketability for their bonds.
Selecting the right bond issue has become increasingly difficult because of the growing complexity of the market. Is a general obligation bond better than a sales tax bond? Is a lease structure more or less secure than a covenant to budget and appropriate? How can investors equate the revenue pledge of A-rated hospital bonds with an A-rated water/sewer issue?
The hospital represents a competitive entity that depends largely on the health insurance industry and constantly changing government reimbursement procedures. The water/sewer issue is based on a monopoly "user fee" for an essential service.
Hospital and utility credits with the same rating are really quite different securities with very different levels of risk. Since many individual investors do not have the credit skills or resources to tell a good bond from a bad one, they are increasingly relying on the guarantee provided by bond insurance.
This lack of consistency in credit security features contributes to municipal bond liquidity or the lack thereof. Market inconsistencies can be perilous if an issuer is suffering from a market perception problem. For example, the holder of a double-A California GO bond would have found that the spread of that security over a triple-B Massachusetts GO bond narrowed from 80 to less than 20 basis points over the last year.
While the ratings have not changed, the market perception appears to be that California is a deteriorating credit while Massachusetts is an improving one. Is the market overreacting? The spread between a triple-B state GO and a double-A state GO should reflect a greater difference than 20 basis points, considering that one is barely an investment grade and the other virtually tops the rating category scale.
One way for municipal bond investors to assure themselves of constant credit strength is through insured municipal bonds. The extra layer of triple-A security provided by credit enhancement not only aids investor protection but also smooths out the market fluctuations between different credit quality features.
Take, for example, New York State appropriation debt, which was recently downgraded by a major credit rating agency. At the same time, the GO debt rating of New York State held constant. The result is a two-tiered rating for two types of state debt that are dependent on the same revenue source. Holders of New York appropriation debt are being penalized because appropriation is perceived as a weak security feature.
Bondholders of the insured New York appropriation debt, however, experienced little difference in value because of the market's reliance on the bond insurer's triple-A ratings.
The value of insurance has been greater when it comes to market liquidity. Holders of bonds that have deteriorated into the noninvestment-grade category can always find a market for their bonds if they are insured. Holders of insured Philadelphia and Bridgeport bonds saw the value of their investment essentially maintained while the uninsured bonds fell dramatically in value. Insurance also helps insulate investors from fluctuating market spreads like those experienced by California and Massachusetts bondholders.
Another inconsistency in the marketplace is that triple-A insured paper actually trades in the lower double-A range. Market experts attribute this to the growing market penetration of insurance. For the first five months of 1992, a record 35% of all new municipals sold with insurance.
The high volume of insured paper coupled with the scarcity of true triple-A's have created differences in trading levels. As the insurers and the rating agencies educate investors about the value of the guarantee, this spread should begin to narrow. Clearly, more investors have been protected over time by the creditworthiness of insured bonds over the triple-A bonds. According to Standard & Poor's Corp., there were 120 triple-A rated issuers in 1971. Only 18 of those were still rated triple-A in 1991. No monoline municipal bond insurer has ever been downgraded.
Today's individual investor cannot risk the chance that his credit will be perceived as weak in a relatively illiquid municipal market. Insured bonds should be an essential element in an investor's portfolio to ensure credit consistency, enhanced liquidity, and added security during these uncertain economic times.
Neil G. Budnick is senior vice president, group director of tax-backed and utilities products of the Municipal Bond Investors Assurance Corp.
