CIT, California and the Fallout in Today's Bond Markets

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
July 29, 2009

Key points

By most measures, bond markets are healing—the most significant sign being the narrowing yield spreads between riskier, more credit-sensitive bonds and US Treasuries.
CIT is jostling with bondholders to renegotiate or exchange various classes of bonds for restructured securities or repayment at a significant discount from original par value.
We believe a widespread collapse in municipal bonds is unlikely—there are few other investments with more structural and legal protections.

What's been the fallout from the problems with two very different stories, CIT Group Inc. and the state of California? So far, a lot of news, but not much movement in bond markets overall.

Still, CIT's troubles and California's budgets do matter—and not just to investors who hold their bonds. The volatility and losses have been significant in the case of CIT, and muni investors' nerves have been on edge across the board.

Let's look at why, digging in deeper to specifics concerning both CIT and California, and investments in corporate and municipal bonds.

Bellwether events?
By most measures, bond markets are healing, the most significant sign being the spreads between the yields of riskier, more credit-sensitive bonds and those of the safest bonds (US Treasuries). They've been narrowing steadily since December, with a bit of a hiccup when the stock market bottomed in March.

The largest difference in yield between an index of investment-grade and comparable Treasuries reached 6.8% (or, in bond speak, 680 basis points) on December 3. Since then, this spread has declined to 280 basis points.

A spread of 280 basis points means that an average investment-grade corporate bond is currently generating a yield greater than a Treasury bond with similar maturity of 2.8%.

Going back to 2002, the historical average has been 170 basis points (1.7%). The chart below provides more detail.

Corporate bond yields compared to Treasuries

Source: Bloomberg.

The size of this spread is the price, or "premium," that the market is demanding to hold bonds with some credit risk compared to bonds with virtually none (i.e. Treasuries). The higher those spreads, the higher the price the market demands to take that risk. This includes price volatility and perceived increase in the chance of default.

Even with this narrowing in these spreads, or the "price" of risk, the Federal Reserve hasn't pulled away the training wheels it's been providing by holding interest rates at record lows, purchasing Treasuries and other government-backed bonds, among other extraordinary measures.

But the collective forces of economic and financial policy in Washington—i.e. the connected but sometimes conflicting forces of the Fed, the US Treasury, the Federal Deposit Insurance Corporation (FDIC), the White House, and others—have concluded for now that both CIT and California must go their own way.

This may be a stabilization point for bond markets. For CIT, federal officials seemingly have drawn the line on bailing out every troubled firm. Maybe it's because they believe the economy is strengthening, or they believe that "moral hazard"—personal responsibility for risk—has returned.

Whatever the government's motivations, its removal of the safety net makes investing in individual corporate bonds more difficult to predict.

For California, the feds have left the Golden State to work out its financial problems on its own. Given the size of the federal deficit, it's reasonable to expect that Washington can't provide a backstop to—or bail out—municipalities, as well.

But will there be a line in the sand here too—on government expenditures, taxes, the cost of public employee benefits and social services? The heated politics, structural challenges and economic fall-out are a microcosm of municipal politics nationwide, albeit on a larger stage.

The twists and turns of CIT
Thus far, the united forces of the FDIC, the Fed and the Treasury have refused to provide CIT with federal support. Management is jostling with bondholders to renegotiate or exchange various classes of bonds for restructured securities or repayment at a significant discount from original par value.

What is CIT, by the way? It's not Citigroup, though the confusion is understandable. CIT is one of the oldest commercial lending firms that help small- and medium-sized businesses obtain credit, and retailers (like Macy's, for example) "securitize" their receivables before you and others pay your Macy's credit card bills.

The seesaw of this story is the business model of CIT, as well as the possibility of failure—in an exchange offered to some bondholders to exchange their bonds for something else, will they be better off accepting those new terms at a discount from their original investment, or risk bankruptcy if restructuring fails?

It's in CIT's interest to convey that the latter is likely, if its lenders—primarily large institutional investors, but possibly some retail investors, as well—don't go along. But every desperate step taken by CIT does not ensure its long-term success. Consider CIT's business when you decide whether to hold or sell CIT bonds.

Such restructurings or exchanges are becoming a common story. GMAC completed bond exchanges successfully earlier this year, pushed along by government involvement to help prop up auto industry lending, and Ford Motor Company did the same. General Motors attempted it, but failed.

What are the implications for corporate bond investors?
We believe that situations such as CIT's are a very strong argument for individual investors to seriously consider the pluses and minuses of holding individual bonds versus mutual funds.

It's easier to achieve diversification with funds, for investors with less than $100,000 to allocate to individual corporate bond investments. And fund managers, especially those with larger holdings of a particular issuer, may be better able to negotiate for bondholder interests.

In "normal" markets, highly rated corporate bond issuers are relatively stable. But when credit tightens, or we experience a crisis such as we have during the past year, it's more difficult for an individual investor to anticipate a decline in any particular bond investment—especially if you need to sell before maturity.

Defaults are not the only concern. Market consensus that the risk of default has increased (even if it's not imminent) is enough to send bond prices lower.

Global speculative-grade (that is "junk") bond default rates were 10.1% in the second quarter of 2009, and are projected to rise to 12.8% in the fourth quarter of 2009 before falling back from there.

This is higher than the peaks experienced during the 1991 and 2001 recessions. The historical annual average since 1982 is 2.5%.

Investment-grade default frequency is far lower. Since 1982, it's been 0.05% for issuers still at investment grade. The high was less than 0.4%, in 2002. Of course many issuers start at investment grade, and are then downgraded.¹ And the prices and demand, if you do need to sell, can change.

Moody's projects the highest default rates during the next year for speculative-grade businesses in airlines, media (broadcasting, printing, publishing, advertising), hotels and gaming, and durable consumer goods.

The lowest projections are in utilities, government-related issuers, and banking and insurance (somewhat counterintuitively in the case of the last two—but banks now enjoy strong government support, and insurance companies are not frequent bond issuers).

We know now, however, that rating agencies are often not the best indicator of future distress. Absent comfort from and confidence in ratings, your best protection is likely to be sound independent credit analysis and diversification.

Like stocks, when looking at individual corporate bond issuers, consider how comfortable you might be owning company stock. Stocks are more volatile, but earnings and equity performance are generally not far removed from credit problems, or changes in bond price.

We feel confident about high-grade corporate bonds overall as an investment, as a healing economy helps. But we don't feel as comfortable with that strategy if you hold only a few corporate bond issuers.

How to invest?
If you choose individual bonds as all or part of a solution, we suggest that you hold no more than 10% exposure to any single issuer—calculated as a percentage of the total allocation to corporate bonds and uninsured municipal revenue bonds—and no more than 20% to any single industry.

There aren't many mutual funds dedicated to corporate bonds alone, though several ETFs are available that focus on indexes of corporate bonds.

You can refer to the ETF Screener on Schwab.com.

Log in to Schwab.com and click Research > ETFs > ETF Screener and look for taxable bond funds.
Two examples include the Barclays Credit Bond Fund (CFT) or the Barclays Intermediate Credit Bond Fund (CIU). But review recent performance and a prospectus before making any investment decision.

You can also choose an intermediate-term bond fund, and a good place to start could be the Schwab Mutual Fund Select List®. Most fund managers will have some exposure to corporate bonds, and will make tactical decisions for you when it might be best to move back and forth between corporate or other less credit-sensitive bonds.

The tightening trap of California budgets
It's become an annual ritual for California to make national news as it struggles to balance its budget. This year, due to a precipitous shortfall in tax revenue, the crisis has been worse and the solutions less clear.

The state began to issue IOUs for "noncritical" expenditures in July, to make sure it would have enough cash for "critical" costs this fall, such as school funding and bond payments.

One pressing concern for the state and other municipalities is the annual need to issue short-term cash-flow "notes." In normal years, money can be borrowed early in the fiscal year (which begins July 1) to tide governments over until tax receipts come in the following spring—many municipalities do this.

California has done so in 19 out of the past 20 fiscal years, in the form of revenue anticipation notes (RANs) that are sold to tax-exempt money market funds and individual investors.

Without a budget or credit support (i.e. insurance), California hasn't been able borrow the cash it needs. So the legislature has been forced to tackle the minefields of partisan politics to try to balance the budget, to keep the state solvent, and convince Wall Street that it's a sound investment.

Without that, the state treasurer had said the state might need federal backing, to help guarantee the notes (RANs) it needs to solve its short-term cash flow problem. That support has been rejected.

California is dysfunctional in many ways, but the fact that a budget was passed, with sizable cuts across constituencies, demonstrates that states take their debt obligations very seriously. Politics may make this difficult, but during the entire crisis, there's been no discussion by state officials about default on bonds.

We've heard questions about New York City's and Cleveland's problems in the 1970s, or Orange County in 1994. Did they default when they faced severe financial troubles?

Neither New York City or Cleveland defaulted on long-term general obligation bonds during their major budget crises, nor did they file for bankruptcy.²

Orange County continued to pay on its debts during its 1994 bankruptcy.³

The city of Vallejo, in California, and Jefferson County, Alabama—the latest casualties in the muni world—have continued to make regularly-scheduled interest payments on bond obligations, as well.

Municipalities have problems, but they're resilient. They're generally able to do what's required (eventually) to make the adjustments they must to ensure that they can pay on bond obligations regardless of economic conditions.

The same can't be said of private corporations. Default rates historically for corporations are far higher than for investment-grade muni bonds during the past 30 years, at least, and we believe the same will be true for the next 30 years, as well.

What are the implications for muni bond investors?
Given the size of its economy, there's good reason California makes headlines. But it's not alone—other municipalities also face similar problems.

The past 25 years in public finance (i.e. the world of muni bonds) have been stable. The economy has been strong, and service needs (including pensions and retirement costs) have remained under control.

However, municipal revenues aren't likely to rebound anytime soon. And like the federal government, many will face tough decisions about the rising cost of services, especially retirement pensions and health care costs.

But we believe a widespread collapse in municipal finance is unlikely. To bet on this would be a bet against any form of stability in the national economy. There are few other investments with more structural and legal protections.

The alternative is Treasury bonds. And yields on Treasuries are at record lows, and you pay federal income tax on interest payments, unlike municipal bonds. Interest on Treasuries is exempt from state and local but not federal income tax.

How to invest?
The same themes mentioned earlier regarding corporate bonds apply to munis, as well—careful credit selection and a diversified portfolio. Select the highest-rated general obligation bonds and essential-service (water/sewer) revenue bonds, for starters. These bonds, and their issuers, have more margin for error.

You can find these on Schwab.com at Trade > Bonds > Advanced Search > Search by Products and choose Municipals. Or consult with a Schwab Fixed Income Specialist. There are plenty of well-managed municipal bond funds, as well.

For more insight into individual bond types, see the last question in our "Updated FAQ: California's Budget Crisis and California State Muni Bonds" on Schwab.com, as well as "What's the Story with Munis?" also on Schwab.com. We'll plan to write more about the finer points of municipal bonds soon.

1. Moody's Investor Services, "Corporate Default and Recovery Rates, 1920-2008," on www.moodys.com.
2. In 1975, New York delayed a payment on short-term notes. These generally do not enjoy the projection of a "full faith and credit" "general obligation" (GO) pledge. In 1978, Cleveland defaulted on bank loans, but not long-term bonds.
3. In 1994, Orange County filed for bankruptcy due to losses in the county's treasury portfolio. The county did not default on long-term bonds, but did fail to fulfill an obligation to "tender" (i.e. pay back, on demand) $110 million in county Pension Obligation Bonds (POBs).

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