In this issue of The Institutional Risk Analyst, we feature a comment by John Mouseau, Executive Vice President & Director of Fixed Income at Cumberland Advisors. You can read more of Cumberland's always timely comments on the financial markets at www.cumber.com.
Sarasota | The Wall Street Journal had a story on the front page of the “B” section Wednesday morning about banks getting some relief with regard to counting municipal bonds among their “liquid assets.” On Tuesday the Senate voted to formally debate a bill containing that provision, and it should have enough Democratic support to pass. The debate over this issue has been going on for some time, and we wrote about it in 2015 (http://www.cumber.com/hqla-and-lcr/).
We always thought it was a mistake on a number of fronts that munis were left off the list of high-quality liquid assets (HQLA). First and foremost is the importance of banks in the marketplace. Because of the tax exemption, banks have been buyers of tax-free municipal bonds for years. The level of taxation on municipal bonds clearly has an effect on banks’ decisions to own tax-free or taxable debt. So changes in the tax structure are one input into the buying decision. The banks’ book (purchase) yields are another input, and the designation of bonds as either “available for sale” or “hold to maturity” is another input. (Without getting overly complicated, the distinction is that realized gains or losses from “available for sale” bonds flow into the income statement, while bonds in the second category are generally held to maturity and recorded at cost.)
However, one of the most important purchase considerations is the generally high credit quality of the overall municipal bond market. Moody’s publishes a study that is updated approximately every two years in which it compares municipal bond and corporate bond default rates by rating categories over a ten-year period. In the last report, for 2016, in the broadest category, “A”-rated municipal bonds had a cumulative default rate over ten years of .07%, while that of corporates (globally) was 2.22%. While both numbers are low, the corporate default rate is 31x that of municipals in the “A” category. If you look at the numbers cumulatively, including AAA to A, the default rate for munis is .09% in total and 3.38% for corporates. In this case the corporate default rate is 37x that of municipal debt, which implies that there is higher event risk in corporates (e.g., in high-quality bonds subject to the stress of takeovers).
The fact that high-quality corporates were included in the 2014 bill as high-quality liquid assets but municipal bonds were not has always stuck in our craw. General Electric was rated AAA by Standard & Poor’s up to 2009, when it lost its gilt-edged credit status and is now rated A, yet the State of Maryland has been a AAA credit before, during, and since the financial crisis. Our point is that on a credit quality basis municipals have outshined corporates for many years and in most cases have provided better taxable-equivalent, risk-adjusted yields for banks.
Why would regulators be prejudiced against the muni credit? Our thought is that lobbying by state and local governments was lacking four years ago when these regulations were first promulgated. And there tends to be inertia among banks to modify rules once regulations are in place. But make no mistake; this new bill is a winner for banks and a winner for the muni bond market. Banks may have a lower tax rate but that will not necessarily disturb higher purchase yields. And the fact that munis should be able to be counted as high-quality liquid assets will further cement their part in banks’ portfolios. Indeed, this bill will help Congress put the “quality” into the “high-quality” designation.