Rate spike may lead to U.S. muni 'Armageddon' -SEC commissioner

WASHINGTON, April 16 Tue Apr 16, 2013 2:06pm EDT

WASHINGTON, April 16 (Reuters) - Investors in the $3.7 trillion U.S. municipal bond market could soon face an "Armageddon" if interest rates spike, a member of the Securities and Exchange Commission said on Tuesday.

Commissioner Dan Gallagher told a roundtable of market participants hosted by the SEC that recent bankruptcies in California pose the threat of losses to bondholders.

"You tack that on to rising interest rates and we've got a real Armageddon on our hands here," he said.

"The commission has to pay attention to both of these issues. What role does the protector of investors have with respect to bondholders getting wiped out who thought they were buying inherently risk-free products?"

Both Stockton and San Bernardino in California are considered tests of whether bondholders or pensioners will absorb most of the pain when governments go broke.

Bondholders have traditionally been fully repaid their principal in all major bankruptcies, but those California cities, along with Jefferson County in Alabama, are likely to break that tradition and impose some haircuts.

At the same time yields on the secondary market are edging higher. On Municipal Market Data's benchmark scale for the secondary market, the yield on top-rated 10-year bonds was 1.72 percent and the 30-year yield was 2.92 percent on Monday.

Both were above the record lows they touched in November when 10-year bonds were at 1.47 percent and top-flight 30-year bonds were at 2.47 percent, according to MMD.

When interest rates rise, investors could rush to the exits, which could put the individual retail bond buyers who hold most of the outstanding municipal bonds at risk, Gallagher said.

Many of those buyers are retired, relying on the debt's monthly interest payments for income. Meanwhile, the secondary market is fairly illiquid and only around 2 percent of the outstanding debt is traded daily.

"We can debate around the edges about what role the commission plays when it comes to systemic risk  but for things that are just so squarely in our jurisdiction this issue, exit risk to retail investors when interest rates go up, is probably the biggest thing I worry about," he said.

Speaking at the roundtable, Robert Auwerter, head of fixed income at The Vanguard Group Inc., said he is considering how investors will react to a sudden increase in interest rates.

"We may all be potentially trying to get through the door at the same time to sell if there is a sharp spike in rates," he said. "Liquidity, I would say, is the number one concern at my shop."

The Government Accountability Office found in a study last year that retail buyers tend to pay higher prices for bonds, mostly because they do not have data and other details for comparing prices.

Commissioner Elisse Walter is continuing to push for investor protections in the market after a releasing a report this summer that argued for providing individuals with more access to bond information. At the roundtable, she suggested a "best execution" rule for dealers similar to that used in the corporate debt world and developing more advanced trading and disclosure technology could provide investor protections.

"We all know what's coming when the interest rates rise there is going to be a crushing impact on the value of these securities," said Ric Edelman, chairman and chief executive at Edelman Financial Services, referring to "the tsunami yield curve."

"The markets will survive it but the individuals may not survive it," he added. "That's where I think our primary motivation and focus needs to be for the next couple of years."

Retail's interest in municipal debt has cooled slightly. For six straight weeks the bond funds they favor have registered net outflows, according to IPREO, while the Federal Reserve recently reported that the municipal debt held by households at the end of 2012 was the lowest since 2007 - $1.679 trillion.