Why the Muni Bond Market Is in Decline

Something interesting has been going on since the latter part of November: investment grade corporate bonds (LQD; blue line) have dramatically outperformed municipal bonds (MUB; pink line). Actually, the outperformance is understated in the chart above, as illiquidity among munis has left arbitrage opportunities unexploited, leading to mispricing of MUB relative to its net asset value. The underperformance of municipal bonds has been especially notable at the long end, as shown by Vanguard's fund (VILPX; yellow line), which is making fresh bear market lows, even as corporate bonds rally.

So why are municipal bonds -- which already yield more than their taxable counterparts in the corporate world -- widening their underperformance? Partly, it is a function of risk aversion, as investors flee uncertain investments and instead seek safety in the lower yields of Treasury instruments. Growing budget problems in such states as California and Michigan are also taking their toll on investor sentiment. Indeed, the flight from munis is so notable -- the once safe and stodgy sector is down over 8% this year -- that one money manager plainly states, "The muni market is not working normally."

Even muni issuers such as Goldman have been recommending the purchase of credit default swaps against the possibility of municipal defaults. This default fear has especially rocked the high-yield segment of the muni market, which has seen declines approximating 30%. These concerns, combined with the increased need for hedge funds to invest in the most liquid instruments, has led to a historic divergence in the behavior of munis relative to Treasuries. This weakness recently led PIMCO to suspend dividends in its municipal closed-end funds.

While automakers have gotten most the news this past week, the eroding condition of tax-free credit markets may pose graver problems for municipalities and the many high net worth investors who have sought shelter in tax-free instruments. The dynamics that have led to this historic weakness -- a severe recession slashing state and local revenues and a flight of investors to safety and liquidity -- show no sign of abating, and price declines continue to erode returns from otherwise attractive yields. Meanwhile, the Fed has explicitly stated that it cannot help state and local governments, and Treasury has denied access to TARP among municipalities, further heightening investor anxieties.

Comments

[starkawa:]

My understanding is that the muni sector has a historically low default risk, especially when compared to corporate sector. As the market drags the general obligation muni down as well, it should prove to be a very good mid to long term buying opportunities as GO muni's default rate is almost close to zero.

I can absorb the default of a revenue-backed muni, but if we see GO muni defaulting, I would not want to imagine how the corporate bonds and stocks would be like.

2008 Dec 15 01:57 AM

[.*.:]

PIMCO is doing the right thing....maybe they had to, but it is always the correct thing to suspend dividends to get back into leverage compliance rather than sell distressed securities at the bottom of the market to get back into leverage compliance. Why do these bone-headed fund managers do that--sell at the bottom to redeem the AARPS leverage? [They are required to get to a max 2:1 ratio]. Because they think investors are so bone-headed that they respond only to current payouts, not to preservation of capital. It is sooooooooo stupid--destroying the funds to save the payout--temporarily. I want to tear my hair out.

2008 Dec 15 08:55 AM

[BondGuy:]

If this were a risk aversion story, munis would be outperforming corporates, which are far riskier. The muni problem is largely a liquidity story. TARP has been handled by idiots, who have chosen not to do the single most helpful thing they can do to save jobs and economic activity, which would be to support normal state government spending which has been killed by the non-functional muni market.

2008 Dec 15 10:30 AM

[jmorace:]

If TARP was worked as it was sold to us, MBIA and AMBAC would be bailed out and their guarantees would then be worth something. This would bring a lot of individual investors hording liquidity back into the market.

Without these guarantees, it's treacherous work to figure out the specifics of each muni bond and make a selection.

Too bad the boneheaded execs at MBIA and AMBAC weren't former Goldman employees, then they'd have all the money in the world from their pal Paulson.

2008 Dec 15 12:55 PM

[Hedged In:]

Good article -- helpful insight into the muni bond market.

2008 Dec 15 05:20 PM

[BondMan:]

I must say I agree with BondGuy, if this were a risk averision story we would see money flowing into high grade muncipals which we have not. The buyer of last resort, once large institutions, has been replaced with the retail investors which cannot bear so much supply. Too make matters worse large insititutions refuse to buy munis right now with yields so high in fears of devaluing their portfolios.

Not giving states and municipalities a piece of the TARP pie makes absolutely no sense to me. You wanna increase jobs? Invest in states' infrastructure and such.

I am staying away from the stock market but refuse to park my money in Treasuries when I can buy tax-free treasuries, pre-re's, which are yielding about 170% of treasuries on a nominal basis. On a taxable equivalent basis this is about 300%!.....

2008 Dec 15 11:48 PM

[ignorant:]

Look at closed end municipal funds that are leveraged. They sell at discounts to net asset value in the range of 20-30 %. So the underlying municipals are market distressed and then discounted again by 20% because the closed end fund is leveraged. Many of the closed end funds are partially funded using auction rate securities. Considering the rate uncertainty of using this funding mechanism perhaps some discount is appropriate but how does 20-30% make sense.


On Dec 15 11:48 PM BondMan wrote:

> I must say I agree with BondGuy, if this were a risk averision story
> we would see money flowing into high grade muncipals which we have
> not. The buyer of last resort, once large institutions, has been
> replaced with the retail investors which cannot bear so much supply.
> Too make matters worse large insititutions refuse to buy munis right
> now with yields so high in fears of devaluing their portfolios.
>
>
> Not giving states and municipalities a piece of the TARP pie makes
> absolutely no sense to me. You wanna increase jobs? Invest in states'
> infrastructure and such.
>
> I am staying away from the stock market but refuse to park my money
> in Treasuries when I can buy tax-free treasuries, pre-re's, which
> are yielding about 170% of treasuries on a nominal basis. On a taxable
> equivalent basis this is about 300%!.....

2008 Dec 17 01:05 PM