Jan. 17 (Bloomberg) -- You have probably read a lot of scary stories about the municipal bond market recently. The question is: Should you be scared?
There are currently two kinds of bad news bedeviling the market. One is all about process -- how bonds are underwritten, and what happens after they are sold. The other concerns credit.
Both are serious. Are they going to have an impact on the prices of your bonds? As more bad news is published, is there going to be panic-selling?
These are good questions. They are also the kinds of questions you ask if you think of municipal bonds in terms of the stock market. Big mistake.
When bad news is reported in the stock market, a particular company's stock usually declines, sometimes a lot.
When bad news is reported in the municipal bond market, nothing happens. The municipal market is, or often seems to be, bullet-proof. The market shakes bad news off like a fastball pitcher shaking off the sign for a curve.
This happens even if the bad news is specific to a single issuer. Literally, nothing happens. At most, the bid side, as they call it, dries up temporarily.
Taking Profits
The U.S. Justice Department now is engaged in a massive investigation into what it termed ``anticompetitive practices'' in the municipal market. It is looking at bid-rigging, price- fixing, and kickbacks in connection with the reinvestment-of- proceeds business. After issuers sell bonds, they rarely use all the money immediately; instead, they invest it.
The tricky part about this is that tax rules forbid municipalities from making money on the money they raise in the tax-exempt market. That is, they can't borrow at 4 percent and invest it at 6 percent. If they do, they have to give back the extra 2 percent to the Internal Revenue Service.
Tax-exempt issuers can't make profits. Nor can they give them away. In other words, they can't borrow at 4 percent, invest at 6 percent, and then unwittingly or not, give the 2 percent to the securities dealers who help them reinvest the proceeds.
This is precisely what the IRS has been discovering in its audits of municipal-bond issues. The IRS says some brokers have taken advantage of issuers, and made oodles of money in the process.
FBI Raids
The IRS then presents issuers with the bill. This takes the form of a little dance where the IRS tells the issuers that the interest on their bonds is now going to be considered taxable unless the issuer pays a penalty.
The IRS has been doing this pretty steadily over the past decade or so. The agency finally piqued the attention of those at the Justice Department, and now we have a big investigation that has featured Federal Bureau of Investigation raids and barrels of subpoenas.
You rarely read about all the ``adverse determination letters'' the IRS sends out. That's because most issuers don't disclose them, and their bond lawyers advise them that they don't have to. The lawyers, some of them, reason that issuers would never allow their bondholders to be harmed in such a way, and that of course they will settle with the IRS.
Brace yourselves for all kinds of bad news in the months and years ahead as this investigation moves to the indictment and settlement stages, and all kinds of unsavory details leak. But don't expect the prices on municipal bonds to move much. Bond buyers needn't worry too much. Taxpayers, on the other hand, should probably prepare to get pretty steamed, because this investigation is going to show just how clueless and unsophisticated many municipal finance officers are.
Other Benefits
There are a lot of reasons for the indestructibility of muni bond prices. The older the bond, the less it actually trades. Municipalities don't go out of business; they raise taxes. Issuers tend to settle with the IRS. Finally, most bonds are insured. That's why even after Hurricane Katrina leveled parts of Louisiana and Mississippi, bond prices hardly moved.
More troublesome news is this whole issue of GASB 45. Governmental Accounting Standards Board's statement 45 requires municipalities to account for the ``other post-employment benefits'' they have given out to their retirees, chiefly health- care perks. You may have read about this little situation, which some observers say may amount to $1 trillion or more.
GASB 45 is being phased in. Governments with revenue of more than $100 million were required to start tallying up these retiree liabilities after Dec. 15, 2006. Those with revenue of more than $10 million are going to have to report them after next Dec. 15. Those with annual revenue of less than $10 million are going to have to report after Dec. 15, 2008.
This is a big deal, or may be a big deal, though nobody is panicking just yet. Certainly the people who rate municipal bonds aren't overly concerned. ``Moody's believes that it is premature to prescribe dogmatic treatment of this new and evolving information within the context of credit ratings,'' the rating company said in December in a survey that showed the cost of other post-employment benefits outpacing inflation.
Scary? You bet. Are muni prices going to be battered because of it? Don't count on it.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
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