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Municipal Bond Funds Bleak Future

|Includes: BlackRock California Municipal Income Trust (BFZ)
Editor's Note: This article originally appeared in Jason Farkas' February 12 Weekly Insight column of EWI's intensive Currency and Interest Rate Specialty Service

“In addition to a historic plunge in real estate, and thus tax base deterioration, many municipalities are saddled with derivatives and pension fund obligations that didn’t exist in the 1930s; that problem will intensify as the bear market wears on.”                          Elliott Wave Financial Forecast, February 2009

Typically high-risk bonds compensate investors by paying higher yields than low-risk bonds. But because of the tax-free status of municipal bonds, municipals pay higher after-tax yields than Treasuries do. So, although many municipal bond investors believe they are being conservative by investing in tax-exempt muni debt, they actually buy municipal debt because it carries more yield than Treasuries. This reach for yield will likely come back to bite muni investors once state finances are caught in the teeth of the next bear wave.
But with interest rates near zero, can you blame investors for reaching for extra yield? The 2000s have seen extended periods with very low interest rates which encourage investors to speculate in higher yielding muni bonds. Muni bond funds have also been popular with investors due to:  1. the belief in higher tax rates which are likely needed to accommodate the massive government deficits, and 2. the high distributions they pay.

Though many investors are blissfully unaware, many muni funds employ leverage to pay such high distributions. This added layer of risk means that these funds are subject to the same liquidity concerns that plague other risky assets, and as such, many muni bond funds act similarly to stocks. This highlights Elliott Wave International’s “All The Same Market” idea once again. A chart of the Blackrock California Municipal Income Trust (NYSE:BFZ) has two points that suggest trouble ahead for it others like it.
1.       Dramatic Fall – An impulse wave unfolded from April 2007 until December 2008. After topping before stocks in late 2006 or 2007, many similar funds fell as hard or harder than the 60% drop seen in BFZ. Two such funds are the Alliance California Municipal Income Fund (NYSE:AKP) and the Nuveen CA Income Fund (NYSE:NUC). California isn’t alone as Pimco’s NY Muni Fund (NYSE:PYN) and Van Kampen Ohio Quality Municipal Trust (NYSE:VOQ) show that many muni funds trade together regardless of the issuer or manager.
2.       Corrective Rally – BFZ has rallied in three waves since its December 2008 bottom, which puts it back into resistance and into the Fibonacci .618 area. As the stock market powered to higher highs in 2010, BFZ has been unable to follow. Based on this fund and others, it looks like California’s muni bonds will lead to the downside just like they did in 2007.
Our forecast for muni bonds is bearish. This forecast stands in stark contrast to the rating agencies’ opinions. Not one state carries a non-investment grade rating, and California alone occupies the level just above junk. But, don’t expect the rating agencies to alert investors prior to states entering financial difficulty as these are the same agencies that were oblivious to the real estate bubble. Not only do municipalities face financial difficulties, but they will likely see reduced demand from funds as risk aversion returns in 2010.
The February 2009 issue of the Elliott Wave Financial Forecast stated, “The degree of the [down]turn suggests that muni-bond defaults will surpass the 30% rate of the 1930s.” California had to issue IOUs in order to avoid default in 2009. Let’s see how the other 49 fare this year. 

Jason S. Farkas, CMT

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Disclosure: No positions