By Lisa Lambert
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 in 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 2.93 percent on Tuesday.
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, putting the individual retail bond buyers who hold most of the outstanding municipal bonds at risk, Gallagher said.
“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.
In response to the financial crisis and deep recession of 2007-2009, the Federal Reserve cut official borrowing costs to effectively zero. Officials are currently discussing when they should taper off the stimulus program that has kept interest rates across the United States low for years.
Looking into the future dealers, traders, brokers, advisers regulators and issuers are asking themselves a question posed at the roundtable by John Cross, head of the SEC’s municipal securities office: “How to address and manage the ultimate unwind of the Fed’s ‘zero interest rates for as far as the eye can see’ policy?”
Robert Auwerter, head of fixed income at The Vanguard Group Inc, told the roundtable, he is pondering 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.”
Following the old adage of “what goes up must come down,” Craig Noble, managing director and head of retail fixed income at Wells Fargo Advisors, said he is telling clients that bonds currently trading at a premium could go below par. But he said “they will mature at par.”
He added that “99.9 percent of our clients will get out of the bonds at par, which is a tough lesson because they haven’t seen that for the last 20 years.”
Likewise, Brad Winges, head of fixed income sales, trading and underwriting for Piper Jaffray, said prices, which move inversely to yields, will go down. Those drops will push discounted bonds to what is known as their “de minimis” much faster than investors expected. Holders of discounted bonds must pay ordinary income tax on any amounts beyond the de minimis.
“Prices are going to start algorithmically dropping as the de minimis starts coming into play,” he said. “That has not come into play significantly because, historically, we’ve been in a bull market for a very, very long time.”
The municipal bond market is largely illiquid and most bonds do not trade on a daily basis. In many cases, individual investors buy and hold the debt - according to Federal Reserve data they have 45 percent of all outstanding municipal bonds - to use the interest payments as income.
Major shifts in interest rates and prices will threaten smaller-scale retail buyers, said Ric Edelman, chairman and chief executive at Edelman Financial Services, referring to “the tsunami yield curve.”
“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,” he added. “The markets will survive it, but the individuals may not survive it ... 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 municipal debt held by households at the end of 2012 was the lowest since 2007 - $1.679 trillion.
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 market and developing more advanced trading and disclosure technology could provide protection for investors.