Bond Market(s): End(s) of Western Civilization as we Know It

The following is right, isn't it?  The typical municipal bankruptcy is (and will be) a three-way fight: current employees versus retirees versus bondholders (with taxpayers languishing already beaten in the corner). Sure there is some overlap: you might say  younger/newer employees versus older-plus-pensioners, but it's a fine point.  Anyway you look at it, three into two don't go and something will have to give.

Bondholders clearly know it. The reason you know they know it is that we are beginning to hear those voices telling us how it  can't be that bondholders will ever suffer in a muny bankruptcy; that it will be the end of Western Civilization as we know it!

Right, sure, maybe, whatever.  Sounds a lot like how they tell us that it can't be that bondholders will suffer in a bank failure either; that it would be the end of Western Civilization as we know it!

With banks, the claims strikes me as particularly egregious, recognizing that we start off with insured debtors who have a formal protection against loss--which the banks have more or less paid for--and try to extend the same kind of protection to those who do not have that protection.

What the bondholders do have in each case is not a formal protection; rather they have the assurance that they've got a pretty safe investment--one which, over the long horizon, has done pretty well.  But a bond is still just an IOU, even if tarted up in its Sunday best.  It's a claim; it's on the right hand side of the balance sheet.  It's ahead of equity, but it may or may not get paid in full.

One reason the pious affirmation gets so tiresome is that a moment's reflection give you a little context as to how these bonds came into being.  I.e., somebody had to loan the money and for all practical purposes the landscape presented prime opportunities for guys with suitcase-sized brains (or so they said) whose specialty was  hoovering up  the detritus from the Mayberry mafia.  Was anybody better equipped to appraise risk?  Was there ever anyone less entitled to say "oh, it's munies and they always pay"--?

But one thing I don't know, in either case: how often does it actually work?  We know a lot about failure rates among corporate bonds in the post-Milken generation. We've learned, among other things, that first-tier corporates never were quite as bulletproof as conventionally assumed.  But what, exactly, is the record of munies (or, while I am at it, of bank debt)?  Is there really  substance to the assertion that "they never fail"--?  Or is the landscape actually scattered with more corpses than our memories account for?

The War Bond

My friend Anupam is not old enough to remember FDR--or Adlai Stevenson, come to think of it--so I had to educate him on Series E War Bonds.  I got one for--it must have been my eighth--birthday in 1944.  It looked to me like money.  I knew that it had cost $18.75 and promised pay $25 after 10 years.    That pencils out to a (geometric mean--(25/18.75)^0.1-1) annual return of 2.9 percent.   I remember reading somewhere that the campaign was designed partly to raise money but also to suck liquidity out of the economy so as to prevent inflation.    Using data compiled by the indefatigable Ashwath Damodaran, I find that the implied yield on a regular 10-year Treasury for the same period would have been ((218.57/172.12)^0.1-1) an annual return of about 2.4 percent.  So actually my piddly little E bond did better than the market.

Unfortunately stocks, by contrast, would have yielded a whopping annual average return of 16.7 percent.   I once told Anupam the bond ended up looking like a pretty cheesy return.  What are you complaining about, he said, you won the war didn't you.

Afterthought:  I remember getting the bond.  I have no recollection whatever of cashing it in.  I gather there are billions of dollars' worth of old government bonds languishing unclaimed.  Do you suppose I am one of them?

If You Didn't Want to Go to Providence, Why Did you Get on the Train? Bondholders Get Themselves Paid Twice in Rhode Island

Honestly, am I the only person (outside of the Rhode Island public employees) outraged at the insolence and arrogance of the bondholders who have decided they won't be getting enough on their contracts in prospective Rhode Island municipal bankruptcies? Faced with the prospect of a shortfall the bondholders have just shoved through a piece of legislation that bumps them to the head of the queue.  As Reuters explains:

The law adopted last month gives municipal bondholders a lien on taxes and general revenues collected by the cities and towns whose bonds they buy.

This means the bondholders would be repaid before other creditors such as workers, suppliers and pension fund beneficiaries if the municipalities went bankrupt.

I've got a better idea.  Let's pass a law giving first priority to all bloggers whose screen names begin with "B."   It would make about as much sense as prioritizing precisely those people most likely to have the motive, the opportunity and the wherewithal to estimate this risk and (this is important) to price it into their original loan?  Assuming (as I should think we are permitted to assume) that they have already charged for this bankruptcy haircut, if we now let them stick it to the general fund, aren't we just paying them twice?


I suppose I could be wrong if we find a document in the file that says "and besides, boss, if there ever arises a real risk of default, we just get our lapdogs friends in the legislature to change the law."  Then again, I guess if they really did plan it that way, then they weren't getting double paid after all.

Ooh, That's Gotta Hurt...

Moody's downgrades Harrisburg because doubling property taxes is not enough to solve the problem.

"Own Goal" in the Bond Market

In The Meltdown Years, Wolfgang Munchau says:

There are stories when banks sold default insurance against their own default.

Munchau calls this "a logical absurdity," and he's got that one right. Consider

• For consideration given, we promise to pay you $10 million.

• For an additional $330,000, we promise that if we fail to pay you $10 million, we'll pay you $10 million.

Uh--right. With Munchau, I am sure there are "stories." And it does indeed sound like just exactly the sort of travellers tales that one of our brave venturers would bring home from the banking wars. But is it any more than that? Can anyone identify a confirmed sighting?

You will surmise that I am skeptical. True enough, but I can imagine this: much (most?) credit insurance was written in indexes--e.g., the Itraxx Index, which measures the performance of bonds of companies with good credit ratings. I can imagine that some banks wrote insurance on indexes of which their own bank issues were a part. That's a slightly different matter from what Munchau is proposing, although I grant it is not much less cray.

Hey, I Used to Own One of These!

Somebody--Yglesias?--was talking about War Bonds in World War II. Hey, I used to own one of these! Given to me for my--seventh? eighth?--birthday. The face was $18.75 and the maturity was 10 years with a maturity value of $25. This all looked like pretty heavy sugar to me but I suspected--correctly, as it turned out--that I'd never see any of it. Probably went for something silly like education.

My recollection is that it was a 10-year term bond. I've long assumed it was a pretty terrible investment, but here's something I didn't know how to do in those days: extract the 0.1th root out of that series and you have the implied annual rate. So (25/18.75)^(1/10)-1 = just a shade under three percent. The CPI Calculator shows me that the inflation rate starting in 1943 was about four percent. So, it is a loser.

But wait, folks. Flipping through my copy of Homer and Sylla A History of Interest Rates (I knew I would be glad to have this book someday), I find that the yield on a prime corporate bond in February (birthday month!) 1943 was 2.57 percent--in 1944, just a gnat's eyebrow different, at 2.56 percent.

So the government bond was actually better than a corporate (and come to think of it, as I recall, the income on each was taxable).

Meanwhile, if I count right, the return on the Dow was about seven percent annual, without counting dividends. But there is that pesky business of capital gains...