It’s far too soon to know how bankruptcy will affect Detroit’s bondholders, pensioners and taxpayers. It’s not too soon, however, for issuers coming to market to glean definitive insights from what’s happened so far. Key among them is what this experience tells us about changes under way in the municipal bond market.
Before talking about Detroit, let’s look at bonds from the investor’s viewpoint. There are basically two ways to make money in the municipal bond market. One is a “duration bet.” Here an investor buys a long-term bond expecting that interest rates won’t change or will decline. If interest rates go up, the interest payments from that bond become less valuable. To protect against this, many investors make a simultaneous and opposite bet—or “hedge”—with, say, short-term U.S. Treasuries.
The second way to make money is with a “spread bet.” An investor buys a bond with some expectation about the future spread between the yield on that bond and a benchmark yield. Spreads narrow or widen when a bond’s credit risk changes or when its yields are more volatile. To hedge a spread bet, most investors will bet on some asset with spread characteristics similar to the bond in question.
For the past 50 years municipal bonds were a wonderful duration bet. Regular folks bought and held them to generate tax-exempt savings for retirement or for college. Insurance companies used them to shore up their own long-term risk exposures. It wasn’t flashy, but this duration strategy produced solid investment returns over time.
By contrast, it has been tough for muni investors to make money on a spread bet. The reason: There’s no good answer to the question, “Spread to what?” As it stands, there are bonds in the muni market from more than 50,000 state and local governments. Those bonds are backed by hundreds of different revenue sources governed by a dizzying array of state laws. Slightly different bonds from the same issuer routinely trade at wildly different prices. At the moment there’s no broadly accepted method to compare bonds to one another to compute meaningful spreads, much less bet with or against those spreads.
Yet much of this has changed since the recent financial crisis. Greater volatility and a prolonged period of record low interest rates have wreaked havoc on duration bets. Many muni investors have gone back to the drawing board. In pursuit of a new strategy, they are rethinking the feasibility of spread bets.
To that end, an army of municipal analysts are working to organize the many shades of muni market gray. They’re applying sophisticated data mining techniques to uncover hidden patterns in muni yields. They’re combing through state and local governments’ annual financial reports. They’re developing statistical models to predict how prolonged long-term interest rates will continue to shape the municipal market.
That’s why Detroit is important. It gives us a first glimpse into how sophisticated investors are applying their new insights. Mom-and-pop investors, worried about losing their nest eggs, have exited the market in force. At the same time, a separate and more sophisticated group of investors figured out how to keep the good Detroit debt—namely the bonds backed with dedicated and protected revenues—and ditch the bad. They built portfolios around a far more nuanced understanding of how to manage the unique risks inherent in such a delicate situation. While everyone else is running scared, they’re properly hedged for the long term.
To thrive in this changing marketplace, state and local governments need to tell their own unique stories in the language of spreads. They need to articulate to investors who to use as their benchmark, why they’re better than that benchmark, and how they’re hedging their own risks.