The Municipal Bond Dilemma

In addition to the normal components used in the process of evaluating municipal bonds, two additional and very important factors exist in the municipal bond market today. Those two factors are the consideration of current levels of interest rates and the perceived risk stemming from mortgage backed securities and municipal insurance companies.

First of all, most of us realize that the FOMC is focused primarily on growth at this time and secondarily on inflation. With that, most of Wall Street expects the FOMC to be accommodative near-term if they need to be. However, most of Wall Street also understands that the interest rate cuts that are taking place now will be reversed once the economy starts to be gain traction. That means interest rates are low respective to where they are likely to be six months or a year from now. In a normal market environment, the inverse relationship between interest rates and price tells us that muni prices, everything held constant, are likely to decline when the recent interest rate cuts are reversed out of the market.

Second, the risk factor associated with municipal bonds is serious enough to make municipal bonds comparably attractive in today's market environment. Again, everything held constant, if an investor was able to identify a bond issued from a municipality that had significant debt coverage, a value would be identified, higher market values would be warranted for those bonds when the current environment improved and a a value opportunity would present itself. In many separate instances, this exact scenario probably holds true, and therefore there are probably many comparative value options in this market, everything held constant. Municipal bonds may be beaten up too much based on the problems facing Ambac (ABK), Fannie Mae (FNM), MBIA (MBI), and the others, and when the problems with these insurers work their way through the system a valuable arbitrage player would assume that bonds with high debt coverage would increase in value.

Conjoined, the first and second points mentioned above create a balanced risk environment, and the value added proposition is diluted. Because municipal bonds already have comparably higher yields due to risk one might think that price appreciation lies ahead. However, if Interest rates reverse too, all bets are off.

The value proposition may be, if you're going to buy any bonds, buy municipal bonds because their prices are likely to be much more stable than other bonds given the interest rate landscape that lies ahead of us. However, if you are looking for anything else from this equation, you may be barking up the wrong tree. Municipal bonds are not likely to increase in value once inflation becomes more of a priority to the FOMC.

Comments

[Kurtis]

MBIA and Ambac had quite the scam going while it lasted. Moody's and the other rating companies would underrate municipal bonds and then Ambac and MBIA would swoop in and offer their Aaa ratings in exchange for some $$. Isn't teamwork wonderful! Well now congress pressured Moody's to give Municipal bonds the Aaa rating without Ambac or MBIA. There goes their business. Another Wall Street scam bites the dust. Along with it the fortunes of Ambac and MBIA. They're left with no business and a mountain of debt. I can't wait until their stocks slide into oblivion where they belong.

[mar del plata-buenosaires]

These stocks are already down 80-90%. I cannot figure out why anyone including Tillson and Middleton to talk trash about these companies, as they hang on to the coatails of Ackman. What good comes from burying these companies? More unemployed people? Are any of you guys American, or just posing? Can anyone find some foreign companies to short... Short some foreign stocks for a change. Change your flavor. Leave ABK and MBI alone, write about solutions. Stop manipulating the little bits and pieces that are offered up. Let the stocks run their natural course, and then you can say you were right or wrong with a little dignity.

[crashof2008]

I see. This does sound like socialism however. Are you stating we are not allowed to disclose facts that California last week announced they will no longer use MBIA to insure their new muni issues? New Jersey has now followed suit. Are you claiming this will have no effect on their bottom line, or that because we live in a socialist society we should not be able to discuss that?

Are you saying that because we live in a socialist society we are not allowed to short the stock?

My, my.

If MBIA is such a wonderful AAA company, why do they have to pay 15% to borrow money in the capital markets? That's junk bond rate and is what they borrowed money when they raised emergency capital in the debt markets earlier this year.

Should that fact also be kept secret?

Matt