Did Vanguard and Dimon 'Ring a Bell' to Buy Municipal Bonds?

Includes: MUB, NEA, VGM
by: George Spritzer, CFA

There is an old trading adage that says: “Nobody rings a bell at the bottom”. But there is another time tested trading rule that says: “Successful traders buy into bad news and sell into good news”. The second rule can be especially relevant when the bad news appears as a cover story of a major financial publication.

One of the best examples of the second rule in action was the BusinessWeek cover story “The Death of Equities”, which appeared in August 1979. At the time, the stock market had experienced serious losses and inflation appeared to be a major risk to the long term health of the US economy. The article stated several convincing reasons why double digit inflation would kill equity returns permanently.

Of course, we now know that the stock market staged a very strong comeback in the twenty years that followed. The BusinessWeek article missed the mark because it was a static analysis and assumed that nothing constructive would be done to address the problems. It turns out, the BusinessWeek article did a good job of “ringing the bell” to signal the stock market bottom.

In the last quarter of 2010, there was a sharp correction in municipal bond prices caused by several supply/demand factors:

  • Municipal bond supply was greater than usual because legislative uncertainties caused municipalities to move up future issuance prior to year end. The expiration of the Build America Bond program was a major catalyst.
  • Retail demand became weak because of uncertainties about the tax bill, expiration of the BAB program and increasing market volatility. The top tax bracket was not increased which added to price weakness.

Normally the above factors would be self correcting. Heavier bond issuance in the fourth quarter has lead to lighter new issuance in the first quarter. But there has been a significant increase in media attention to the municipal market which has caused many retail investors to start selling their municipal bond fund holdings. After many months of inflows, there have now been three straight months of significant outflows.

Much of the media coverage has been filled with largely uninformed yet sensational stories of upcoming disasters in municipal finance. This has scared many retired “mom and pop” retail investors who have naturally sold some of their municipal holdings.

There have been three significant stories that have moved the markets:

  1. December 19: Meredith Whitney's appearance on 60 Minutes. This has been widely discussed in the financial media and on financial blogs.
  2. January 12: Jamie Dimon, CEO of JP Morgan Chase, said he expected more municipal bankruptcies at a JP Morgan annual healthcare conference. Dimon also said at the conference: “If you are an investor in municipals you should be very, very careful”. At first I found Dimon’s comments to be quite surprising, but I now believe he may have just been “talking his book”. JP Morgan Chase acquired Bear Stearns high net worth asset management business during the 2008 market meltdown. Many of these high net worth investors have large holdings in municipal bonds. By telling these investors “to be very, very careful”, he is encouraging more trading activity in municipal bonds (e.g. swapping from riskier credits to higher rated bonds). Secondary market spreads are much higher for municipal bonds than for equities, and are quite profitable for JP Morgan Chase. Mr. Dimon may also be trying to build up the municipal bond credit default swap business by telling institutional clients to be “very, very careful” and buy insurance. Again the CDS market has fat attractive bid-asked spreads. The JP Morgan Healthcare conference was on January 10, but the story first appeared on Bloomberg and Huffington Post on January 12.
  3. January 13: Vanguard Postpones Municipal Bond ETF Launch. I am surprised that Vanguard decided to postpone their municipal bond ETF launch which leaves them with egg on their face. Vanguard used the excuse of exceptional volatility and an unstable municipal bond market to justify the postponement. They wanted to avoid launching the funds in an environment “that we believe will likely impede their ability to track their respective benchmarks”. This statement seems very weak. Suppose Vanguard had launched these ETFs a year ago. Does the recent increased volatility mean they would stop supporting existing ETFs? I would hope not. It appears that Vanguard’s primary motive is to game the ETF tracking statistics versus their competition who will continue to support their municipal bond ETFs through this turbulent period.

Of course Vanguard wants to protect their existing municipal bond mutual fund business, and they certainly do not want to encourage more municipal bond fund outflows. So they made sure to include the following disclaimer:

However, this does not suggest that you advise clients not to invest in municipal bonds or municipal bond mutual funds that may be appropriate for their particular investment objectives. Review our latest research which explains why we believe the doomsday headlines regarding the municipal bond market overreach reality.

I’ve listed the dividend-adjusted closing prices for several ETFs and municipal bond closed-end funds to see how they would have done assuming you bought at the close of the day following the media report.

  • Dec. 20, 2010: Day after Meredith Whitney appearance on 60 Minutes.
  • Jan. 13, 2011: Day after articles on Jamie Dimon.
  • Jan. 14, 2011: Day after articles on Vanguard’s postponement of municipal bond ETFs.

MUB - iShares S&P National Muni ETF

  • Dec. 20, 2010 98.88
  • Jan. 13, 2010 97.31
  • Jan. 14, 2010 96.26
  • Feb. 11, 2011 100.79

NPM - Nuveen Premium Income Municipal Fund 2

  • Dec. 20, 2010 12.86
  • Jan. 13, 2011 12.48
  • Jan. 14, 2011 12.36
  • Feb. 11, 2011 13.15

VGM - Invesco VK Trust for Investment Grade Municipals

  • Dec. 20, 2010 12.92
  • Jan. 13, 2011 12.44
  • Jan. 14, 2011 12.26
  • Feb. 11, 2011 13.08

You would have a small profit if you purchased any of these funds on December 20, after Meredith Whitney's appearance on 60 minutes. But a better time to buy would have been right after the back-to-back Jamie Dimon-Vanguard media articles which seemed to “ring the bell” signaling a market bottom.

Disclosure: I am long NPM.