Are Municipals Allergic to Basel?
One of the bogeys of the Basel Accords calls for dramatic improvements in bank liquidity. The most recent changes to the Liquidity Coverage Ratio (LCR) test changed the numerator in the equation to ease the strictness of qualifying assets. The formula divides a banking institution’s stock of high quality liquid assets (HQLA)—the numerator—by estimated total net cash outflow over a 30-day period in a stressed environment. The calculation must be at least equal to or greater than 100 percent at all times.
The original description of HQLA was only comprised of cash and sovereign debt. Pressure from the banking sector allowed HQLA to include a second tier of debt instruments along with associated haircuts. Tier I assets are 0 percent risk-weighted sovereign debt (e.g. U.S. Treasuries) and cash. Tier II assets, which may be used to meet up to 40 percent of HQLA, include GSE debt and certain corporate bonds rated at least AA-.
Notably missing from the list of Tier II instruments are municipal bonds, regardless of rating. As one may surmise, this has rubbed some folks the wrong way - primarily state treasurers and other state and local officials. The governmental agencies responsible for our application of Basel, the Federal Reserve, The Office of the Controller of the Currency and the Federal Deposit Insurance Corporation—came to the conclusion that municipal bonds do not provide enough liquidity to qualify for HQLA inclusion.
Over the past few weeks, the Wall Street Journal, Barron’s, and Bloomberg News among others have all featured articles about the possibility that municipal bond prices will go lower as a result of the new liquidity formula’s exclusion of municipals. Let’s look further into the story and try to figure out what’s really going on.
According to the Federal Reserve’s Statistical Release of June 2014, the amount of outstanding state and local government debt is estimated to be $3 trillion, down slightly from its high in 2010. There has been a steady reduction in overall municipal debt of around 1 percent per annum over the past 4 years, likely due to a reduction in the level of refunding issues in the period. Virtually all the low-hanging fruit has been picked since the beginning of the rally in 2009.
On September 1, 2008 the AAA muni level for one-year paper was 1.70 percent, and today it’s 0.11 percent. Similarly, 10- and 30-year bond yields fell from 3.75 percent and 4.75 percent to 2.2 percent and 3.18 percent, respectively. Bankers will try to convince issuers to refund any callable debt once there’s a 4 percent present value saving. Because of the pressure to refund callable debt at present levels, there have been tremendous numbers of transactions effected. That party is pretty much over. In addition, with the tepid pace of recovery among state and local governments, there remains reluctance to borrow for new capital projects. So, we have declining supply.
So, who owns all these bonds and what’s been the buying pattern over the last several years? Again, relying on the Fed’s Statistical Release, we learn that the financial sector owns $1.95 trillion in municipal bonds—roughly two thirds of the market. The breakdown of ownership is as follows: long-term bond funds own on behalf of their shareholders $615 billion; banks have $419 billion; money market funds own $308 billion; life insurance companies have $134 billion; property and casualty Insurance companies add $325 billion to the total. Primarily individuals own the remaining balance of outstanding muni debt, either directly or in safekeeping at their financial intermediaries. One may safely assume the primary reason for ownership is the tax-exempt nature of the income associated with the investments.
Since the economic disaster of 2008, property/casualty holdings have fallen by $57 billion while life insurance companies have increased their holdings by $96 billion. From 2008 to 2012, municipal bond funds grew by more than $263 billion before experiencing outflows of some $13.5 billion last year. This was probably due to a combination of factors: the ongoing rally in equity markets, the bad news associated with bankruptcies or threats thereof in Detroit, Puerto Rico, and a number of local governments in California withering under the weight of pension liabilities and overly generous pay packages for employees. On the other hand, banks have seen their holdings double in the same time frame. From a base of $222 billion in mid-2008, banks now own $419 billion in municipal bonds. This extraordinary growth and its potential demise is the cause of all the hand wringing in various state capitals around the country.
Let’s look further into this picture and try to figure out what’s been going on. One might look to eliminate favorable returns from the equation, though on a tax equivalent basis municipals were cheaper than treasuries for a long time. Rather, recall that the Fed has been pouring money into the banking system month after month after month. At the peak of QE3, monthly injections were at least $85 billion. During this time, the two primary lines of business for banks—business and mortgage loans—were virtually moribund. With little impetus to feed these traditional business lines, many banks put the new liquidity to work in the marketplace. If you as a bank are not making business loans or mortgage loans, you have to do something with all that cash. Municipal bonds, particularly in the front end of the yield curve were among the immediate beneficiaries of the Fed’s largesse. Even now, as the level of monthly cash injections fall to $25 billion with further reductions imminent, markets seem to take this information in stride. There is no noticeable weakening at the front end of the curve.
So the question is, what happens if the regulators leave municipals out of the equation when they release their final iteration of HQLA? Despite the anxiety expressed by state treasurers and other debt management officials, our best guess is that the impact will probably be nominal. At most, we believe this may lead to a slightly steeper yield curve over the first several years. Lower Fed infusions, a lower level of municipal bond issuance, and continued demand from other sectors should cushion the adverse effect of lower bank purchases, if they occur. In addition, investment bankers and underwriters are not tied to any one structural requirement when they design a new issue. While governmental borrowers prefer level debt transactions for their predictable payment requirements and cash flow management, there is plenty of room to maneuver within the general constraint. Given this maneuverability, if there is a sudden weakening in demand, bankers will do their utmost to shift principal repayments further out the curve.
Finally, as long as municipals represent value compared to alternative investments on a tax equivalent basis, demand will expand to meet the supply. We are at historical low levels for the cost of funds, and, consequently, it will take very large adjustments in yield to create a noticeable impact to the municipal market. For example, a 25 percent increase in yield for one-year bonds will change the level from 0.12 percent to 0.15 percent, in one year, from 0.50 percent to 0.625 percent in two, and from 1.10 percent to 1.375 percent in 5 years. Frankly, in the overall scheme of things, this is hardly more than statistical noise. If you want to see what a real correction looks like, just take a gander at the Treasury 2 year note from January to October 1987. Now that was a correction.
While investors have been sufficiently warned that the municipal market may be moving from bull to bear to dinosaur, we take exception. It is apparent that Basel III requirements may exclude municipal bonds as high quality liquid assets. However, we do not see the absence of muni bond assets for LCQ tests as much more than a regulatory aberration. Banks currently hold approximately 14 percent of outstanding municipal bonds. We believe that with decreases in supply, there is more than enough demand to hold municipals at near current levels. Remember: Not All Bonds Are Created Equal.
Good Fortune!
Bob Andres is editor of The Andres Review and founder of Andres Capital. Bob’s career includes stops as: chief investment officer at Merion Wealth Partners, chief investment strategist at Envestnet (PMC division), co-founder at Martindale Andres & Co., a firm he grew to $2.4 billion before its sale, President at Merrill Lynch Mortgage Capital, etc. He has been quoted and featured in various media: CNBC, Fox Business, Barron’s, Institutional Investor, etc.
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