Colby is Portfolio Manager/Municipal Bond ETFs with more than 30 years of fixed income experience.
It is not my place to offer a politicized opinion on the current Washington stalemate and debt ceiling crisis. In fact, the potential consequences of not extending the debt ceiling and facing payment default on the nation’s debt are already being well documented by others. The potential impact on the muni bond market, however, is in my purview. In my opinion, pre-refunded municipal bonds, a corner of the municipal market that is not well known by even those familiar with municipals, may be squarely in the crosshairs of this calamity. "Pre-res," as they are commonly called, are bonds that have been refinanced; their future payments of coupon and principal are secured by an escrow account consisting of U.S. Treasuries and/or State and Local Government Series (SLGS). These are direct obligations of the United States Treasury Department, which implicitly attributes the pre-refunded bonds with the same credit rating as the U.S. Government. I believe the concern with respect to impact of the government shutdown on municipal bonds is not for the ultimate recovery of the principal amount but for the potential cessation of payment of income due to the bondholders for any of these pre-refunded bonds with current interest due. Pre-refunded bonds may be often found within institutional portfolios and generally are held, I believe, as a ready store of liquidity. Individual retail investors, who in my experience tend to be unwilling to take on unfamiliar credit risk, often use them in a similar way. I don’t believe that an interruption of coupon payments would likely have a significant impact on the broader municipal market, but I do think it could certainly leave a bitter taste in the mouths of those who have long seen pre-res as dependable payers of the highest quality available in the municipal market.
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