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The $2.8 trillion municipal bond market certainly had its fair share of turmoil recently.

Some munis saw their biggest one-day rise in yields and drop in price since the worst of the financial crisis. But overall, yields remain below and prices above Fall 2008 levels.

Matt Fabian, managing director at Municipal Market Advisors, described it this way: “There is a complete distrust of municipal credit among retail investors and the public at large. People took it [the selloff] as a sign that the credit collapse in munis is coming.”

Lipper, a fund-tracking firm, agrees. Individual investors, it reports, withdrew a record $3.1 billion from mutual funds and ETFs holding municipal bonds last week.

The hardest hit investments have been closed-end municipal bond funds. Unlike open-end funds, they issue a set number of shares and trade on stock exchanges.

Unfortunately, many of them use leverage – borrowed money – to enhance their returns. Since that only works on the upside, many closed-end muni bond funds have fallen over 10% this past week.

For more on that subject, I urge you to read Alexander Green’s article on why these funds are ticking time-bombs.

Is the Muni Market Still Safe?

Munis have historically been a relatively safe place to invest. Their defaults have been remarkably low since the Great Depression era, and much lower than corporate bonds.

Over the years, individual investors have played a big part in the municipal bond market, either by purchasing them directly or through mutual funds.

They like them because of the tax breaks on that kind of debt. That has then given state and local governments access to cheap funding as they offer lower tax-exempt yields.

But budget deficits and under-funded public pensions now have people wondering if local entities can actually pay off those debts. Many investors believe what U.S. public entities owe could create even more financial risk.

Rising Treasury bond yields and the huge supply of municipal bonds hitting the market before year-end are pushing prices lower as well… along with one other worry…

Build America Bonds at Risk

Institutional investors don’t normally prefer municipal bonds, which don’t receive the tax breaks individuals do. But the financial crisis changed that.

To try to ease financing pressure, the federal government began subsidies for municipalities selling taxable debt to finance infrastructure projects. Those Build America bonds, or Babs, became very popular with institutional investors, even outside the U.S.

The program diverted about $150 billion of borrowing away from the traditional municipal market. And that eased financing pressure, helping to bring borrowing costs from crisis levels to historical lows.

Build America bonds continue to be a success, accounting for about 25% of new munis issued this year. But the municipal bond market could now lose key support.

Republican gains in Congress have raised questions about Washington’s appetite to aid ailing local governments.

Bab’s subsidies may not even be extended beyond a year-end expiration. And even if they are, it could be at a lower rate than the 35% interest the government is now paying.

These doubts have resulted in the wave of municipal bonds sales hitting the market. State and local governments have rushed to raise money before the possible expiration.

If it does expire, the tax-free municipal market will have to accept all that issuance, but may not have the demand to absorb it.

Crowding out would ensue. And each individual issuer would have to pay a higher interest rate to access the market.

States and municipalities are hardly well placed to handle that right now. They already face large budget deficits and rising costs for under-funded pensions.

Murky Muni Future

The muni bond market hopes that Republicans will extend the entire Babs program. If not, the market could sell off drastically.

Meredith Whitney, a noted and outspoken public finance markets observer, recently addressed that risk.

She warned that the idea of low muni bond defaults is based on what happened in “the best 30 years, with nirvana capital markets and state budgets.” She said, “This is not an applicable proxy because there have not been budget gaps this widely spread and to this great a degree, and the political appetite for further stimulus is low.”

Individual investors own $1 trillion of that $2.8 trillion market. If Whitney is right about the number of defaults, there will be widespread selling, hurting a lot of people, and causing another problem for the U.S. financial system.