The path is smooth that leadeth on to danger.– William Shakespeare
Take calculated risks. This is quite different from being rash.– George S. Patton
Never tell me the odds.– Han Solo
Muni bond issuers are at their core, speculators; even ones with the oh-so-safe sounding “no speculation” provisions in their official debt policies. I know this may come as a shock to some but it is simply a definitional truism. Any entity that isn’t fully hedged i.e. has financial short positions matched by long ones and vice versa, is a speculator. They have to take an interest rate view. And last time I checked states, municipalities, 501c3s and other municipal issuers (most corporates too) are generally not in the luxurious and enviable financial position of having assets in size and scope to match off, even approximately, against their liabilities.
At the point the muni treasurer or 501c3 CFO gets a “Thou shalt borrow” commandment from above - city council, school board, legislature, or board of directors – she or he must make a financially speculative decision. Fixed or variable? Variable with a swap? Put bonds? Perhaps a short call feature? Public offering or private placement? etc etc. These are all decisions that expose the entity to some sort of financial risk, if only the risk that one of the alternatives might in hindsight, have turned out better. Some may consider this “opportunity risk” pretty low grade, but risk is risk.
Very few people would dispute that if you’re a muni asset manager, you have to take and manage risk. What sort of duration will you have in the portfolio? How will you analyze call risk and redemptions? What’s the credit exposure? What’s the benchmark and how can I beat it? But when we look at a muni debt manager, they are just as much a risk taker and manager. Aren’t debt managers just asset managers with a minus sign in front of their “holdings”?
But for the dedicated and chronically under-resourced municipal and not-for-profit professionals who manage these often multi-billion dollar debt portfolios on shoestrings, the right interest rate choice has almost zero upside. For example, many issuers have determined that having a certain amount of variable rate debt in their debt portfolio is a good and prudent thing and will probably lower cost over the long-term. There have been hundreds of billions of unhedged tax-exempt variable rate bonds outstanding for years. And over the last few decades that decision has saved taxpayers hundreds of millions of dollars. Is this a widely reported fact? Of course not. What’s the headline? “Variable rate bonds perform great for [insert issuer name]”? Or “Treasurer [name] Brilliantly Pushed for Variable Rate structure in Series 2003A Bonds]”? Nope. Haven’t seen anything like that.
Some issuers decided to issue variable, but also implemented a strategy to hedge some part of the variable rate risk with an interest rate swap. The hope being that this would actually be less risky than natural, unhedged variable rate bonds. That decision, unfortunately for some issuers, involved taking on more of their own credit risk than they expected. That is, the market value on these swaps, which moves more negative as rates go lower, becomes a real potential liquidity problem if the borrower’s own credit deteriorates sufficiently to trigger collateral provisions under the swap documents. Once the credit rating falls enough, the borrower actually has to post collateral to the bank counterparty, exacerbating the liquidity position of an already stressed credit.1 And the amount of these swap values hasn’t been helped with the 10 year UST hovering sub 2%.
But what has happened to those thousands, if not tens of thousands, of tax-exempt entities that really rolled the dice, made an interest rate call, issued variable rate bonds and look like geniuses in hindsight? Where’s the press on this? Who will highlight some of the countless stories of these unsung heroes of muni interest rate risk-taking? Who will wax long about the prudent, but still risky, decision making that’s led to millions in interest cost savings? No one. And on this, the press is nowhere. That is….until interest rates start going up.
1See Jefferson County, Detroit and other distressed names that at this point, likely regret using interest rate swaps