"Those who trust to chance must abide by the results of chance."
- Calvin Coolidge
One of the early lessons of modern finance that I was taught, like many others, in portfolio management class is that correlation is risk in a large diversified portfolio. This lesson for many has morphed into myth in light of the financial crisis. Based upon fairly low correlation calculations in normal market environments, investors thought they held diversified positions in say domestic equities, real estate, or even credit default swaps. However in mathematical terms correlations are time inhomogeneous – that is, they aren’t stable over time. And worse, recent experience showed us that for many of the aforementioned markets in times of stress, when you need diversification most, correlations move to 1; now your subtly engineered, diversified portfolio is one big boulder heading south.
What does this have to do with municipal issuers? Municipal and
tax-exempt borrowers often focus their energy predominantly on cash flow and cost of capital when looking at debt management. That’s not to say mark to market changes are ignored, particularly in the case of liability based hedges which can lead to collateral calls and liquidity pressure, but this is usually secondary to understanding the impact on debt service and budgets.
From a cash flow perspective, the two primary types of cash flow risk factors in which munis dabble are interest rate (say LIBOR) and tax-exempt/taxable ratio (SIFMA/LIBOR) risks. Looking at these two factors, through up and down market cycles including the crisis, we find that the correlation is negative and has stayed negative. Ratio risk performs poorly when rates are low but very well when rates are higher. Market microstructure reasons abound to explain the phenomenon which should give financial managers comfort.
Interesting thing about tax-exempt variable rate demand bonds (VRDBs) is they contain both risks within the structure (no, LIBOR swaps do not
add tax risk – it exists in the VRDBs whether hedged or not!). With many issuers struggling against tight budgets and looking for ways to lower debt service, at least in the near term, how do you determine the optimal amount of each factor? That depends upon your expected view of rates, tax-exempt/taxable ratios, the volatility of each, and the correlation between the two. A good tax-exempt risk structuring tool can get you there.