So What Happened to All Those Predicted Municipal Bond Defaults?

Includes: NAD, NEA
by: George Spritzer, CFA
Late last year, a 60 Minutes episode on the municipal bond market caused many investors to sell their municipal bond fund holdings. According to Lipper, investors have withdrawn cash from municipal bond funds for 24 straight weeks. The show included appearances by Meredith Whitney and several state governors.
Meredith Whitney made her reputation in 2008 by warning that the big banks were in trouble and correctly predicting a dividend cut at Citigroup (NYSE:C). She appeared on the show and predicted the imminent collapse and meltdown of the municipal bond market:

"There's not a doubt in my mind that you will see a spate of municipal bond defaults," Whitney predicted. Asked how many is a "spate," Whitney said, "You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

Several state governors including Governor Christie of New Jersey, described the problems they were having in balancing their state budgets. Here is an excerpt from one of Christie’s statements:

The day of reckoning has arrived. That’s it. And it’s gonna arrive everywhere. Timing will vary a little bit, depending upon which state you’re in, but it’s comin’.

A few weeks later, Jamie Dimon, the CEO of JP Morgan Chase (NYSE:JPM) added fuel to the fire by stating:

There have been six or seven municipal bankruptcies already. I think unfortunately you will see more. If you are an investor in municipals, you should be very, very careful.

Over four months have passed since these dire predictions. The muni market has already begun to address many of the problems associated with the financial crisis and fiscal mismanagement:
  1. New bond issuance has shrunk dramatically in the first quarter. The muni market had its lowest quarterly issuance volume in over ten years. Some analysts expect total new issuance in 2011 to be less than half of last years.
  2. Part of the reason for the lower bond issuance last quarter is a reaction to the especially heavy issuance in the fourth quarter of 2010 when the Build America Bonds program expired.
  3. State and local governments have also been cutting back on non-essential capital projects and have much improved their fiscal discipline.
  4. The decline in new issue volume is helping to sustain muni bond prices and reduce yields.
  5. State and municipal revenues have been improving at a steady rate. Furthermore, state and municipal payrolls have been reduced by 400,000 people in the last three years. Good progress is being made on both the revenue and expense side.
  6. The changing political climate has given state governors more political “backbone”.
  7. The state and local government “bankruptcy” option appears to have been taken off the table.
  8. It looks more likely that Federal tax brackets will be rising which will increase demand for municipal bonds.
  9. Municipal bond fund redemptions have been gradually decreasing as most of the “weak hands” have already sold. I believe we will start to see muni bond fund inflows shortly as confidence returns.
Let’s see how accurate Whitney’s forecast has been so far. If Whitney’s prediction was on target, we should be seeing over $4 billion of municipal bond defaults per week.

Municipal bond defaults actually declined dramatically in the first quarter of 2011 compared with last year. According to Reuters, there have been no major defaults thus far this year. Only nine small issues have failed, totalling $0.25 billion compared to about $1 billion last year. None of the nine issues had an S&P rating.
This is nowhere near Whitney’s projections in the $50 billion range which are off by a factor of 200!
I believe that one of the best ways to participate in the recovery of the muni bond market is to buy national muni bond closed-end funds.
There are many good choices available now at discounts to net asset value. Two of my favorites are the Nuveen Premium Income Municipal Fund II (NPM) and the Nuveen Premier Municipal Income Fund (NPF). They look attractive now because they have high quality portfolios, sell at discounts over 5%, and may raise their dividend payouts before the end of the year.
  • NPM: EPS= $0.0811 Dist= $0.0740 UNII: $0.2120
  • NPF: EPS= $0.0793 Dist= $0.0725 UNII: $0.2234
Disclosure: I am long NPM, NPF.