New Jersey Gov. Chris Christie earlier this week remarked that if the state didn’t clean up its act it could become the next Greece.
If the bond market is to be believed, that prospect is a little far-fetched.
While most sovereign debt has taken a beating during the flight from risk that has plagued financial markets for the better part of a month, taxable municipal bonds have thrived.
According to a Wells Fargo index tracking Build America Bonds — the taxable municipal securities created under the stimulus legislation last year — the average BAB yield has dropped 26 basis points in May.
Meanwhile, with a few exceptions such as the U.S. and Germany, debt from most sovereign nations has been getting hammered.
Debt with roughly 10-year maturities issued by Peru has jumped 30 basis points. Russia’s is up 70 basis points, and Brazil’s has jumped almost 40.
The BAB sector’s performance suggests that while it took a while for investors to warm to U.S. state and local governments, the sovereign debt panic that began earlier this month has fueled a perception that municipalities’ debt is safer than that of many countries.
When panic took hold, investors bought municipal debt.
“We expect to see very good buying of BABs into any sell-off in the market,” said Jeff Bosland, head of tax-exempt capital markets and public finance at JPMorgan.
Bosland added that international investors are growing increasingly comfortable with BABs as an asset class.
Underwriters are still “building out” the international buyer base, he said. He pointed out that foreign buyers purchased about 17% of a $1.1 billion Washington State BAB deal the firm underwrote this week.
It was not always this way.
The stimulus legislation last year established the Build America Bond program, which authorized municipalities to float taxable bonds and collect a federal subsidy in lieu of the customary tax exemption on their debt.
The BAB program and some other stimulus measures created classes of taxable municipal securities that coaxed states and local governments into the broader taxable bond market, where their debt competes for investor attention with sovereign nations, corporations, and structured products.
Some of the first municipal issuers to tap this new product in April last year paid substantial premiums, most notably the New Jersey Turnpike Authority, whose 30-year bonds came to market with yields 370 basis points over Treasuries.
While the spread had narrowed steadily since then, until this latest sell-off states and local governments in the U.S. were not getting as much respect as some sovereign governments — even some lower-rated governments that have defaulted in recent memory.
Nothing illustrates this better than Peru, Ill., a town of 9,835 in LaSalle County, about 100 miles southwest of Chicago.
Rated A3 by Moody’s Investors Service, Peru this year sold $2.5 million in recovery zone economic development bonds, another type of taxable municipal security created under the American Recovery and Reinvestment Act of 2009.
According to Bloomberg LP, at the beginning of the month the debt with a roughly 10-year maturity carried a spread of 80 basis points over the other, better-known Peru — the Latin American country that defaulted on $5 billion in debt in 2000.
This was not exceptional. Often in spite of stronger credit ratings and a superior history of repayment, many municipal bonds traded at spreads to sovereign debt.
Last month, Russia tapped the bond market for the first time since it defaulted on $72.7 billion of debt in 1998.
The bond initially began trading at a z-spread of just 147 basis points, according to Bloomberg.
The z-spread measures the premium one would need to add to every spot on the Treasury curve for the present value of the bond’s cash flows to equal its price.
The spread meant that Russia’s cost of debt was lower than that of Illinois, which had a spread of 152 basis points. It was lower than California’s by a whopping 119 basis points.
At the beginning of May, New York City’s general obligation debt was trading at roughly the same spread as Mexico’s. Sheboygan, Wis., traded at a 60-basis-point spread to Brazil.
The spreads defied historical default statistics.
According to Moody’s, the 10-year cumulative default rate on rated sovereign bonds since 1970 is 6.36%. On rated general obligation municipal bonds, it is 0.01%.
Even including municipal securities backed by a dedicated stream of revenue rather than a full-faith-and-credit pledge from a government body, the municipal default rate is lower both for investment-grade and speculative-grade bonds.
This was before Moody’s “recalibrated” its municipal ratings system moving most issuers in the muni universe into higher ratings categories.
General obligation municipal bonds that do go into default also offer stronger prospects for recovery — often 100 cents on the dollar, Moody’s said.
Investors in sovereign bonds that have defaulted in the past 15 years have more often than not taken substantial hits on their holdings.
Holders of Russia’s defaulted bonds in 1998 ultimately recovered half of their money, according to Moody’s. Argentina’s bondholders from the country’s 2002 default have recovered 30 cents on the dollar.
The tide has shifted greatly in municipalities’ favor since the sovereign debt sector reached full-blown upheaval earlier this month.
When Russia floated its bonds last month, its debt traded only four basis points over triple-A rated Skokie, Ill.
Since then spreads for most sovereign governments other than the U.S. have widened, while BAB yields have plunged in concert with U.S. Treasuries.
Russia’s 10-year debt now trades at a z-spread of 255 basis points, or 130 over Skokie’s debt.
Mexico now trades at a spread of 45 basis points to New York City. Brazil and Sheboygan are just about on par.
Ross Junge, who manages money for institutional clients at Aviva Investors, expects spreads on BABs to continue contracting as investors grow more familiar and comfortable with the product.
“I think it’s a matter of time,” said Junge, whose firm owns about $600 million of BABs. “The market is giving [BABs] respect, but it takes time for them to ultimately price in the risk and return characteristics.”
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