Investor Attention and Municipal Bond Returns

Investor Attention and Municipal Bond Returns

Kimberly Cornaggia1 John Hund2 Giang Nguyen1

1Penn State University

2University of Georgia

Seventh Annual Brookings Municipal Finance Conference

Cornaggia, Hund, and Nguyen Investor Attention and Municipal Bond Returns July 16, 2018 1 / 28

The Big Picture

Question: how informationally efficient is the municipal bond market?Revised Question: do investors in municipal bond markets use readilyavailable information from other financial markets?

Answer: No. The market updates slowly and remains segmented fromother linked markets.

Method: A simple event study, complicated greatly by illiquidity andheterogeneity.More Detailed Method: When bond insurers become distressed and/ordowngraded, we examine when and if returns on Aaa-rated uninsuredbonds diverge from lower-rated insured bonds.


Our Contributions

1 Clean and rigorous analysis of whether muni investors respond toshocks (and which type) affecting the value of their investments.

Both retail and institutional municipal investors seem to ignoreinformation in equity and CDS markets.Changes in ratings for insurers prompt some selling by institutions.Overall, the municipal market remains highly segmented from othermarkets.

2 Novel analysis of whether insurance is valuable. Returns of low-ratedinsured bonds are identical to Aaa-rated uninsured bonds wheninsured by Aaa-rated insurer.

3 Robust methodology for computing indices and abnormal returns inilliquid and heterogeneous markets for use in event study analysis(with statistical inference).


We need an event date (x2)

1 Financial Distress revealed in equity market in Oct/Nov 20072 Loss of Aaa credit rating in June 2008

Importantly, the financial distress of the insurers is almost exclusively due to bad

decisions to insure sub-prime CDO structures, and not due to credit deterioration in the

municipal market.

01/06 04/06 07/06 10/06 01/07 04/07 07/07 10/07 01/08 04/08 07/08 10/08 01/09-100

-80

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-40

-20

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Cu

mu

lative

Re

turn

(%

)

MBIA

AMBAC

The distress-downgrade period is valuable for research design:fundamental creditworthiness has changed but the “label” hasn’t changed.Cornaggia, Hund, and Nguyen Investor Attention and Municipal Bond Returns July 16, 2018 4 / 28

Signs of Distress Clear and Well-Publicized in 2007

From ”How to Save The Bond Insurers,” a 145pg PowerPoint presentation by BillAckman, 11/28/17 (reported in NYT, FT and Reuters, 12/1/17)

From Creal, Gramacy, & Tsay, 2014

CDSGraph


Data (A Contribution by Itself)

1 Mergent Municipal Bond Securities database:3,555,964 bonds issued by 53,045 municipal issuersFinal sample: 763,070 G.O. bonds issued between 1960 - June 2016

2 Mergent insurer’s data unreliable: have only the most recent insurer(original insurer overwritten)

Hand collect insurer portfolio novation data from insurance companies,track down transfered CUSIPs, and re-instate original insurer data

3 Comprehensive ratings histories directly from Moodys and S&Pwebsites (provided by Ryan Israelsen MSU)

4 MSRB Municipal Bond Trade database:After merging with our GO bond sample and cleaning: 4,456,041 tradepairs spanning 2005-2016/06

5 Other data pieces: CRSP, Bloomberg, CRAs’ websites, insurers’websites and financial reports


Key Research Challenges

1 We need: daily returns on insured bond portfolios and oncorresponding benchmark (non-insured Aaa bonds)

2 How to compute daily returns (of insured bond portfolios and ofbenchmark) when munis are so illiquid? (The average bond in sampletrades about 30 times during 12-year sample period 2005-2016/07)

3 CAN’T just use data on the bonds that actually trade on each day tocompute a day’s average:

4 Important to measure portfolio returns employing all observations forall bonds in the portfolio... but how???


Key Research Challenges: Addressed with Insights fromReal Estate Literature

Muni bonds are like houses: highly heterogeneous and very illiquid

Modify tools from real estate economists who use Repeat SalesRegressions (RSR) to calculate house price appreciation indices all thetime (similar to Spiegel & Starks (2016) for corporate bonds)

Apply GRSR (Peng (2010)) to estimate common return index for allbonds with the same insurer, as well as separate loadings for differentunderlying credit rating classes:

∆yi,b,s,l =

s∑t=b+1

τl,tRm,t +

s∑t=b+1

εi,t

Rm,t = common return of all bonds with same insurance wrap, and l indexes the

underlying rating class of bond i

τl,t indicates the time-varying sensitivity of bonds in rating class l tothe overall return pattern of all bonds with the same insurer


Result 1: When Do Insured Returns Diverge from Aaa?

Divergence from true-Aaa returns starts in late 2008 (afterdowngrade)

But not earlier (around time of financial distress in late 2007)

2006 2007 2008 2009 2010-2

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Cum

ula

tive R

etu

rn S

ince 1

/1/2

006 (

%)

Aaa Uninsured

MBIA

AMBAC


Formal Test of Divergence from true-Aaa Return

MBIA AMBAC

F-stat χ2 c.v. F-stat χ2 c.v.

Sub-sample 1: Prior to Distress Date 341.26 507.84 397.83 513.11Sub-sample 2: From Distress to Downgrade Date 147.83 192.70 42.76 187.24Sub-sample 3: After Downgrade Date 2889.16∗ 421.15 928.89∗ 421.15


Result 2: CARs of MBIA- and AMBAC-insured BondsVertical lines from left to right mark: 1) distress date, 2) downgrade date

2006 2007 2008 2009 2010-6

-4

-2

0

2

CA

R(%

)

MBIA

2006 2007 2008 2009 2010-6

-4

-2

0

2

CA

R(%

)

AMBAC

CAR Table Distress CAR Table Downgrade


Result 3: Attention of Institutional vs. Retail InvestorsGranger causality test based on VAR of institutional vs. retail daily net order flow

Sub-sample 1: Prior to Distress Date

Sub-sample 2: From Distress to Downgrade Date

Sub-sample 3: After Downgrade Date

Causality Direction Full Sample Sub-sample 1 Sub-sample 2 Sub-sample 3

Institutional → Retail 8.162∗∗∗ 6.350∗∗∗ 2.181 7.891∗∗∗

Retail → Institutional 4.617∗∗∗ 5.598∗∗∗ 1.500 2.228


Test of Information Transmission Across Linked MarketsExpanded VAR with both insurers

Granger-causality Test (row variable → column variable?)

ABK-Bond ABK-Stock ABK-CDS MBI-Bond MBI-Stock MBI-CDS

ABK-Bond 0.838 2.234 10.257∗∗∗ 1.124 0.655ABK-Stock 0.827 4.333∗∗ 1.129 0.674 0.447ABK-CDS 0.271 0.567 0.463 1.235 1.637MBI-Bond 36.394∗∗∗ 0.451 1.715 1.131 1.566MBI-Stock 1.013 2.226 2.134 2.212 11.828∗∗∗

MBI-CDS 1.766 4.789∗∗∗ 21.232∗∗∗ 0.616 0.659


One Explanation: Maybe Insurance Has No Value?

Then someone should tell the municipalities...

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500

1,000

1,500

2,000

2,500

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

US Municipal Insurance Premiums Collected (millions)(MBIA/AMBAC actual; Estimated Total)

MBIA Premiums AMBAC Premiums Total Estimated Premiums

Total Premiums CollectedAMBAC (actual): 4.688 BillionMBIA (actual): 5.205 BillionTotal (est.): 17.127 Billion


Other Alternative Explanations

1 Maybe there isn’t any default risk?Then it doesn’t make much sense to buy insurance...However, we’ve replicated the analysis with revenue bonds, (whichhave much higher default risk) and they show similar patterns

RevenueReturns RevenueRatings

2 Lehman Brothers, bailouts, and crisisSignificantly negative CARs precede Lehman bankruptcyTrading activities in muni market around Lehman bankrupcy show“business as usual” Detail

Delayed reaction due to expectation of bailout? no such expectationevident in equity and CDS markets on insurers

3 Limits to arbitrageDifficulty in short-selling munis? Negative CARs following downgradeindicate short sale contraints cannot be the entire storyWhat prevents “smart money” from taking advantage of informationalinefficiency? High transaction costs?


Conclusions

Muni market remains informationally inefficient and segmented

Natural experiment designed around collapse of muni insuranceindustry shows:

1 investors ignore insurers’ insolvency widely revealed in other markets,but...

2 do respond to insurers’ loss of Aaa rating

Institutional investors appear to respond ahead of retail investors, butthe market is generally slow in updating

Our paper also offers data and methodology contributions:improved methodology to compute bond returns for illiquid munimarket, overcoming major problems affecting earlier studiescomprehensive database related to municipal bond market, combiningvarious data sources with credit rating history collected from CRAs andhand-collected data on contemporaneous insurer information


Appendix

Additional Results


CARs Around Distress Date (Event 1)No significant CARs before, and lack of evidence of negative CARs after financial distressof insurers is well publicized

Pre-event window

[-20:-1] [-40:-1] [-60:-1]

CAR s.e. CAR s.e. CAR s.e.

MBIA −0.15 0.20 −0.20 0.20 −0.06 0.20AMBAC −0.47∗ 0.31 −0.07 0.31 0.02 0.32

Post-event window

[0:20] [0:40] [0:60]


MBIA 0.85∗∗∗ 0.36 −0.03 0.23 −0.23 0.39AMBAC −0.15 0.31 −0.68∗∗ 0.40 −0.37 0.57

Go back


CARs Around Downgrade Date (Event 2)No significant CARs before, significantly negative CARs after loss of Aaa insurance rating

Pre-event window

[-20:-1] [-40:-1] [-60:-1]


MBIA −0.07 0.25 0.22 0.26 0.28 0.26AMBAC −0.33 0.39 −0.27 0.39 −0.07 0.40

Post-event window

[0:20] [0:40] [0:60]


MBIA −0.48∗∗ 0.27 −0.41∗ 0.28 −0.87∗∗∗ 0.29AMBAC −0.74∗∗ 0.40 −0.79∗∗ 0.43 −0.15 0.47

Go back


Result 4: Information Transmission Across Linked MarketsVAR of equity returns, changes in CDS spreads, and insured bond portfolio returns

Granger-causality Test (row variable → column variable?)

Insured Bond Stock Return CDS Change

Panel A: MBIA

Insured Bond 1.687 1.665Stock Return 0.075 55.352∗∗∗

CDS Change 0.031 0.052

Panel B: AMBAC

Insured Bond 0.047 0.000Stock Return 0.002 44.400∗∗∗

CDS Change 0.982 3.123∗


Institutional Investors Selling Ahead of Retail InvestorsDaily ratio of institutional sell volume to retail sell volume

Jan 2006 Jul 2006 Jan 2007 Jul 2007 Jan 2008 Jul 2008 Jan 2009 Jul 2009 Jan 20100

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More charts


MBIA and AMBAC CDS and Implied Rating

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Cumulative Returns for Revenue Bond Indices

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Cumulative Returns for Revenue Bond Indices by Rating

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Trading Activity Around MBIA Distress and Downgrade

Institutional Trade Volume around Distress Date

10/18/2007

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n p

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Buy

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Retail Trade Volume around Distress Date

10/18/2007

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Institutional Trade Volume around Downgrade Date

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Retail Trade Volume around Downgrade Date

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Trading Activity Around AMBAC Distress and Downgrade

Institutional Trade Volume around Distress Date

10/25/2007

10/26/2007

10/29/2007

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10/31/2007

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Retail Trade Volume around Distress Date

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Institutional Trade Volume around Downgrade Date

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Retail Trade Volume around Downgrade Date

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Go backCornaggia, Hund, and Nguyen Investor Attention and Municipal Bond Returns July 16, 2018 26 / 28

Trading Activity Around Lehman Brothers Bankruptcy

Institutional Trade Volume

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Go backCornaggia, Hund, and Nguyen Investor Attention and Municipal Bond Returns July 16, 2018 27 / 28

Demise of Monoline Insurance Industry

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

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Number of GO Bonds (Right Scale)Volume Share of Bonds with InsuranceFraction of Bonds with Insurance

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Investor Attention and Municipal Bond Returns

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