Municipal Bonds’ Wild Ride on the Financial Market

September 29, 2009Articles The Legal Intelligencer

Capital Gains

Almost unnoticed amid the recent carnage that has taken place in the financial markets is the vast displacement that has occurred in the tax-exempt bond market during the same time period. And while many of the causes are the same, the large disruption in the municipal bond market did not have to be that bad.

Once a sleepy alcove of the financial markets, the tax-exempt market had thrived on a steady diet of fixed-rate, long-term bonds. The market had seemingly perfect symmetry.

Investors in high tax brackets (often individual investors) sought safe returns that were free from federal and state taxes. Issuers (states, cities, municipalities, hospitals, universities, etc.) received ready access to capital at low rates thanks to the subsidy provided by the government. Even borrowers without stellar credit ratings could participate by purchasing municipal bond insurance, which enabled them to obtain low rates for a reasonable premium payment. While rates would rise and fall over time, the market was largely immune to the volatility and uncertainty commonplace in the equity market.

Beginning in the early 1990s, things began to change. First came variable rate debt. Rather than issue long-term, fixed-rate bonds, borrowers found they could issue the same long-term bonds but structure the bonds to bear interest at low, short-term rates, which would reset periodically (every day, week or month) based on a published short-term index. Large banks would issue letters of credit to secure payment and provide liquidity for the bonds. Investors could "put" the bonds back to the borrower. This type of bond (known as a "low floater" or "put bond"), was perfect for the growing tax-exempt money market fund industry. While the rates on these bonds fluctuated over time, they were amazingly cheap if viewed over a historic period of 10 years or so...

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