Muni Bonds: Juicy Opportunity for Investors

The states are in trouble and the water is beginning to flow over the dam. On Monday, the Governator - Arnold Schwarzenegger, declared a fiscal emergency in California claiming that the state could run out of money by February. As well, the National Conference of State Legislatures (NCSL) and National Governors Association (NGA) released a letter pleading for the Congress to pass a stimulus package. The NCSL reported that 30 states have shortfalls totaling $30 billion, while California already has a budget gap of $11 billion. Interestingly, municipal bond yields have not responded to these developments and that represents a juicy opportunity for investors.

Currently, 30-year Aaa bonds are yielding 5.6%%, while 30-year Baa bonds are yielding above 9%. In contrast, 30-year Aaa municipal bonds are yielding 5.3%. An historical look at Aaa and Baa corporate bonds reveals that the yields are near all-time highs.

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Furthermore, General Electric (GE) was re-affirmed as a Aaa credit rating Tuesday, even though it announced weaker than expected earnings. The key of course is the earnings part, they still have some. However, California and 30 other states have an "earnings" shortfall.

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If we look at the municipal bond yield curve for Aaa general obligation bonds, it is clear that the yields have not changed dramatically over the last six months, while economic conditions have deteriorated. In fact, the unemployment rate for the U.S. as a whole is at the highest level in over eight years.

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Two of the most populous and economically important states are California and New York. Over the last year the unemployment rate in California has risen to all-time highs. It is not difficult to deduce that the higher unemployment rate means people spend less and fewer taxes are collected. Throw in a legislative reluctance to raise taxes and voila, an economic crisis.

Great charts, but how do we make money from this?

The simple answer is to short municipal bonds and the easiest way to do that is to sell short the iShares National Municipal Bond ETF (MUB). This ETF primarily invests in Aaa rated municipal bonds and over 30% of the portfolio is concentrated in issues from California and New York.

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While investors have been running into the U.S. government bond market, they have ignored the municipal bond market and its inherent weakness. Once the market realizes that these Aaa rated muni bonds are less safe than both Aaa and Baa corporate bonds, then the yield should increase while price decreases to reflect the new risk premium.

Disclosure: I am short MUB.

Comments

[vinyasa:]

Interesting thesis and there is no question states are in trouble but repayment risk? Not much on General Obligation bonds. The factor you overlook is that investors in munis look at tax equivelant yields which right now are near 8% on 5-10 year GO AAA bonds. Comparing that to the corporates it is very attractive although not without risks as some would believe. GOs are backed by taxing authority. The state would have to reneg on repayment and the feds would have to not back stop them for these to go under.

You may be right on more suspect revenue bonds for dubious projects but in general the risk reward on shorter term GO munis is pretty good.

I do own GO bonds directly ranging from 3-7 years and am getting nearly 8% AT yields.

2008 Dec 03 09:53 AM

[DougM:]

So, what, the federal government is pouring $100 billions into entities like AIG, and $10 billions into the automakers, but it's going to let 30 states including the two biggest states in the country go down because they're collectively short $30 billion?

2008 Dec 03 12:46 PM

[BondGuy:]

Obama has virtually guaranteed he's going to support state infrastructure spending, and Mayor Bloomberg is even pushing for the federal government to guarantee municipal bonds, which would make their values soar. Under these circumstances, how the idea of shorting municipal bonds makes sense is beyond me.

2008 Dec 04 09:43 AM

[Chancer:]

The problem in CA is that the politicians will not make the necessary cuts in out of control spending growth. They have only been trying limited cuts to get them to the next crisis. When reality sets in, the real cuts must come.

And as others have said, there is always Obama and the Feds to bail them out.

Shorting assumes all of this will not happen.

2008 Dec 04 12:30 PM

[kurt walter:]

We don't have a revenue problem in California. We have a spending problem by those in the legislature that waste taxpayer money because it is not their own money and they don't give a rip.

2008 Dec 05 08:44 PM

[Cassy:]

ARE YOU STILL in go munis and may I ask where you purchase them?


On Dec 03 09:53 AM vinyasa wrote:

> Interesting thesis and there is no question states are in trouble
> but repayment risk? Not much on General Obligation bonds. The factor
> you overlook is that investors in munis look at tax equivelant yields
> which right now are near 8% on 5-10 year GO AAA bonds. Comparing
> that to the corporates it is very attractive although not without
> risks as some would believe. GOs are backed by taxing authority.
> The state would have to reneg on repayment and the feds would have
> to not back stop them for these to go under.
>
> You may be right on more suspect revenue bonds for dubious projects
> but in general the risk reward on shorter term GO munis is pretty
> good.
>
> I do own GO bonds directly ranging from 3-7 years and am getting
> nearly 8% AT yields.

Jan 16 11:33 AM