Risks in the Municipal Bond Market: Follow the Signs

Demand was so intense for $900 million of bonds issued yesterday by the state of Illinois, it drove yields 15 basis points below expectations.

Yes, we know. This is the same state that’s about $5 billion behind on its bills and whose pension system is in the worst shape of any state in the union. It’s the same state Moody’s downgraded last month.

It’s also the same state that the credit default swap (CDS) market rates a 3-to-1 shot for default.

Still, 29% of the bids came from overseas – where the 6.95% yield isn’t even tax-free – evidence enough that the global markets are pining for anything with a decent yield.

True, under the Illinois constitution, bond obligations are the first bills paid every month – before schools, law enforcement, pensions or anything else. But “in the meantime,” warns Allstate CEO Thomas Wilson, ”the value of those securities will go down as people readjust risk. We’re more worried about the market value than ultimately not getting our money back.”

Allstate (perhaps not ironically headquartered in Illinois) has trimmed its muni holdings by 13% over the last three quarters. An insurance giant holding $20 billion in munis is seeing the same subprime-style risks we outlined in the last issue of Apogee Advisory:

  • Widespread investor acceptance
  • Complicated derivatives
  • Intense incentive for banks to make deals
  • Boneheaded assumptions of endless return on investment
  • Loads of underqualified borrowers
  • Stunning amounts of leverage and debt
  • Social and political pressure to grow at all costs

The multi-trillion-dollar muni market remains loosely regulated, and despite high-profile mishaps in the subprime market, municipal bonds still carry overstated credit ratings from Wall Street’s finest firms.

The Illinois bonds are Build America bonds. As elsewhere, they’re federally subsidized, authorized by the 2009 stimulus bill to back infrastructure projects. As folks in many states are being reminded at considerable expense…

As seen outside Chicago. Average cost of these signs in Illinois: $680

Illinois has spent nearly $650,000 for 950 of these signs. A single sign on the road into Dulles Airport in Washington, DC cost $10,000. At least, folks get a warm and fuzzy every time they get stuck in traffic next to one of them. That’s real stimulus.

Addison Wiggin
for The Daily Reckoning