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Hedge funds are stalking the $2.9 trillion municipal-bond market like an alley cat stalks a mouse.

In their public statements, Wall Street shills continue to dismiss warnings about "deadbeat states," and the horrific impact that budgetary shortfalls at the state and local level are going to have on this stodgy slice of the debt market. Anyone who tries to buck this Wall Street view is ridiculed and dismissed as a financial Cassandra.

Behind the so-called "velvet rope," however, some hedge funds not only believe that financial catastrophe looms in the muni-bond market; they're positioning themselves for the kill ... and for the obscene profits they'll reap when this "inevitable" disaster strikes.

But why should hedge funds be the only beneficiaries? I'm going to outline a strategy that promises at least two very generous hedge-fund-style plays related to municipal bonds. At the very least, you can use these strategies to protect yourself from the approaching collapse of the municipal bond market.

And, if you're so inclined, the strategies could potentially make you a bundle.

The Real Reason for the Municipal Bond Mess

Just this week, Nouriel Roubini -- an economist who was one of a few "Cassandras" to actually predict the credit crisis and market collapse -- said investors can expect $100 billion in defaults over the next five years.

When formulating their budgets, state and municipal leaders around the United Sates are supposed to follow a single very simple precept: Don't spend what you don't have. In other words, elected officials and their appointed colleagues typically aim to make sure that the projected outflows for ongoing operating expenses and proposed capital investments don't exceed expected tax receipts and federal subsidies.

Because of the financial downturn -- and especially due to the bursting of the U.S. housing bubble -- many state and local governments are failing to make ends meet. As bad as that seems, it isn't the worst of the problems that governments have to face. In fact, it's the outstanding pension fund obligations they still face that threaten to drive them over a cliff.

And those obligations -- $700 billion to $4 trillion, depending on what actuarial assumptions you choose -- are gargantuan.

How could this happen? Very simple. These pension obligations ballooned because:

  • Politicians tend to not contribute sufficiently to pension funds (and sometimes even raid them) instead of raising taxes to meet other budget shortfalls.
  • Due to prior commitments, generous benefit payouts are scheduled to be paid out over longer periods of time (especially since workers retire earlier and are living longer) while budget-cutting layoffs will reduce the pool of contributors to fund present and future obligations.
  • Actuarial assumptions about investment returns on fund assets are nowhere close to being met in our current environment, which is defined by super-low interest rates and very high stock-market volatility.

With the budget-and-deficit woes facing municipalities, states, and the federal government -- not to mention last year's resounding Republican victory in the midterm elections -- it didn't take long for municipal-bond investors to see the writing on the wall.

Early Tremors

Tough-talking Republicans and fiscal conservatives warned that there wouldn't be any federal bailout for serial over-spenders at the state or municipal levels. That lit the fuse on a muni-bond crisis that we've been warning readers about for some time (including in a number of investment-strategy stories).

As all that rhetoric escalated, municipal-bond investors fled the market. In the past 14 weeks, $38.7 billion, or close to 7.3% of all municipal-bond assets, were withdrawn from municipal-bond mutual funds, according to Lipper FMI. From Oct. 1 of last year to Jan. 18, The Bond Buyer's 40-bond index of top-rated nationwide issuers rose 105 basis points (1.05 percentage points) to reach 5.95% -- its highest yield in two years. That index is closely watched, since The Bond Buyer is the "blue book" of the municipal bond sector.

That knee-jerk dumping of bonds in muni-land was decried by the mostly well-to-do investors who own the bulk of these tax-free and taxable state-and-municipal obligations. But it was greeted warmly by hedge-fund sellers.

If you followed the headlines but missed a chance to get out of some of your muni-bond holdings or wanted to short the market to profit from its recent sell-off, don't be disheartened. Consider what happened to be just the first phase of this downturn in the municipal-bond market.

Trust me, that's precisely how some hedge funds see it. On the other side of the velvet rope, those investment pros are analyzing, strategizing and biding their time.

A Look Inside the Muni-Bond Market

The muni market is what I call a "private" market. Municipal bonds don't trade on formal exchanges. They trade over-the-counter. That means that dealers use their interconnected screens, the Bond Buyer blue book, dealer-posting sites and the telephone to set "bids" and "offers" on almost all muni bonds. The luxury for dealers is that they "make markets" and determine spreads.

What's important to understand here is that when muni-bond mutual funds had to meet heavy redemption requests starting last October, they had to sell their inventory through dealers. While dealers are always looking to take in inventory on the bid (cheaply) and sell it on the offer (for a relatively risk-free spread profit), what they don't like is having a lot of bonds building up in their inventory.

So when the market gets heavy -- meaning there are a lot of bonds for sale -- dealers look to place "offered" bonds with buyers (and not into inventory) if prices are falling. And since buyers are usually "sold" bonds by salesmen who place dealer-desk inventory, the allure of higher yields generated a lot of outgoing sales calls.

The municipal-bond market is a "thin" market. Approximately 70% of all municipal bonds are held by private investors. And more than 33% of all muni bonds outstanding (about $473 billion) are held in mutual funds.

Given how quickly redemptions were hitting mutual funds -- with individual investors "lightening up" at precisely the same instant -- fund managers knew that dealers would be "stepping away" from bidding on offered bonds and that buyers would be hard to come by.

To avoid getting killed when they sold positions, fund managers had to sell the most-attractive, most-creditworthy and most-liquid bonds in their funds. And even these bonds were being sold at ever-lower prices.

As thin as this market is, fund managers were able to pull this off without a complete market collapse ... this time. That's because, before it went over the cliff, the muni-bond market reversed course and started to rebound. With tax-free yields approaching 6% on 30-year-maturity bonds, non-traditional buyers stepped in and began buying.

And that wasn't the only rebound catalyst. At the same time that big fund companies such as PIMCO began referring to the elevated yields that now existed in the marketplace as a "buying opportunity," states announced that third-quarter tax revenue was up 4.75% from a year ago. What's more, the states forecasted that revenue was expected to trend even higher in the fourth quarter of the 2010 calendar year.

Illinois boosted its personal-income-tax rate from 3% to 5% (a 67% increase). And that state's closely watched $3.7 billion issuance of taxable general-obligation bonds was mercifully oversubscribed.

Statehouses around the country further fueled this newfound optimism. They declared an open season on unions' collective bargaining rights and on the unions' once-sacred pension-benefit packages. The ensuing rally drove the Bond Buyer benchmark index down to 5.73% last week and gave muni-bond investors hope for the future.

But this is all just smoke and mirrors.

Cruising for a Bruising

The hedge-fund set knows that there's more trouble to come, and that municipal bonds are going to get hit hard -- perhaps very hard.

The fact that states are watching their revenue trend higher looks good in a vacuum. But it will take years for U.S. states to make up for the 30% decline that they suffered in 2009. As for tax hikes helping, don't count on it. The Illinois levy won't take effect until 2012, which is no help to the state now as its deficit grows and pressures mount on its social services.

It's not possible for any state or municipality to retroactively raise taxes, so any other tax hikes around the country won't be of any near-term help to indebted governments.

But what about the recent market action that's seen municipal-bond prices increase as yields declined? Well, that part of the game is about over.

The reason that yields started falling and prices started rising after the recent sell-off is that subsequent speculative buying by non-traditional, yield-hungry players of the high-quality bonds that mutual funds were dumping occurred in an almost never-before-seen vacuum of new issuance: It goes without saying that bond prices will rise and yields will fall when there's no supply.

The killer news here is that when issuers come to market, en masse -- as they have to -- the federal backstop known as the Build America Bonds Program won't be there to lean on. The BAB Program -- signed into law on Feb. 17, 2009 under the American Recovery and Reinvestment Act -- expired on the final day of 2010. While the program was in effect, taxable bonds issued by states and municipalities qualified for a 35% interest-rate subsidy for issuers, or a refundable tax credit to bond buyers. Of $670 billion total municipal issuance in 2010, a full 27% (or $181 billion worth) were BAB issues.

The End Game in the Muni Market

In the face of all this evidence, it's impossible to ignore the shellacking that the muni-bond market is in for. There's no way the cascade of upcoming state and municipal finances being rolled-over and refinanced -- combined with the expected or projected new muni-bond issues -- won't flood an already-thin market. Indeed, this will create so much supply that dealer spreads will be wide enough to drive trucks through ... even if those dealers actually pick up their phones.

Before that happens, you can be sure that smart hedge funds who get the timing right will be loading up on credit-default swaps (CDS), shorting bonds, and positioning themselves in any exchange-traded funds that that they can profit from as the municipal-bond market drives straight towards the proverbial cliff.

Right at that point -- when the muni-bond market is teetering on the precipice of total collapse, with some prices at 50 cents to 75 cents on the dollar, and near-double-digit yields -- the shrewdest traders will be loading up their trucks. Members of that in-crowd already have their strategy worked out. They know that, after the storm, there will be a rainbow.

They know this because they've already done their homework. They know that, while Chapter 9 bankruptcies may be in the cards for many municipal issuers, and maybe even some states (if proposed legislation is ever passed), Chapter 9 is a "technical" default and not a true monetary default.

Chapter 9 provides a way to negotiate pension benefits, union wages and just about anything else that has to be addressed to "refloat" state and municipal governments that can't ever really go "out of business."

Over the past 40 years, studies by Moody's Investors Service (NYSE:MCO) have shown that the median trading price of defaulted muni issues 30 days after default is 59.5 cents on the dollar -- as opposed to 37.5 cents on the dollar for defaulted senior unsecured corporate bonds.

While corporations can be liquidated and bondholders get what they can grab, states and municipalities will mostly be righted -- their debt payments lowered and their maturities extended. So, to keep the capital markets open to states and municipal issuers, bondholders will eventually be made close to (or completely) whole, which means most or all principal and interest will probably be paid.

You don't have to be a hedge fund to play in this sandbox. You may not be able to buy credit-default swaps on muni bonds, but you can short the iShares S&P National AMT-Free Muni Bond Exchange-Traded Fund (NYSEARCA:MUB). It's currently trading at roughly $100.

If you short the ETF there, and put in a 10% stop-loss order at $110 to cover the position if it goes against you (which is a great stop position because MUB has never traded that high), you'll be in a perfect spot to play the swoon in the muni-bond meltdown.

And when the yields on munis approach the double digits, or you've reached your profit target, cover your position and buy, buy, buy.

There you have it. With your newfound strategy in hand, all you have to do is get the timing right. And, if you do, those hedge-fund folks will never seem invincible again.

Disclosure: None

Source: The Looming Muni-Bond Meltdown: Profit From the Collapse - And From the Rebound