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The 'Muni' Menace

Jan. 31, 2011 8:32 AM ET
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Financials have been underperforming the other sectors in the earnings reported this month in the United States. The below estimated earnings of investment giants such as Goldman Sachs and Morgan Stanley in the last quarter of 2010 have been largely attributed to the lacklustre performance of their fixed income divisions. Municipal bonds (or “munis” as they are affectionately called by investors) are state issued bonds in America, and portfolios with significant exposures to munis have not received the sort of benefits that are traditionally attributed to holding such bonds. Wall Street has certainly been hurt by the downturn of municipal bond prices over the last quarter, and there seems to be no respite in sight in the near future.
Municipal bonds are traditionally considered to be one of the safest bonds to hold, and according to rating agency Moody’s, only 0.3% of rated municipal bonds have defaulted between 1970 and 2009 (albeit there were many more defaults of unrated munis in the same period). General obligation bonds are typically considered to be the safest of the subcategories of municipal bonds, followed by revenue bonds. Municipal bonds generally produce a rate of return that is higher than that of government issued debt but are not much riskier and hence prove to be attractive investment opportunities for investors looking for less than extraordinary returns.

Ever since the recent financial crisis hit, and after the much publicised default of the city of Vallejo in California, the safe haven status of municipal bonds has been repeatedly questioned. Off late, municipal bonds in the United States are being compared to sovereign bonds of the member countries of the Euro zone. Much like their European counterparts, the Federal states in USA have been racking up ever increasing deficits and are trying to finance ever increasing spending. The question of how to be austere while continuing to spend in order to stimulate positive momentum in sagging economies is one that has not found any practical answers. It is more than evident from the experiences of the peripheral economies in the Euro zone that the two contradictory approaches to pacifying increasing bond yields cannot work in tandem.

The yields on municipal bonds have been rising for a variety of reasons. The yields on the ten year T – Notes are a good leading indicator of where the yields on municipal bonds are heading. T notes have had a rally back to the 3.5% levels over the last few months after decreasing substantially on expectations and announcement of the second major asset purchase programme known as QE2 in the beginning of November by the Federal Reserve. Although yields on T Notes remain in a long term (30 year) downtrend, I am concerned by the fact that investors have not been assuaged by QE2. Bond yields have crept up rapidly after the initial optimism driven by the announcement has worn out even though the asset purchase programme is scheduled to last until June.

Another factor that is a cause for concern for investors in the municipal bond market has been the termination of the Build America Bonds programme which was started to alleviate some of the lack of funding issues that federal governments were battling with after the collapse of the real estate bubble. The programme was terminated on the last day of 2010 on the basis of a Senate vote, and I suspect there are going to be many more filibusters that impede correct economic decisions from being made because of the resounding victory of the Republicans in the Mid –Term elections.  

Build America Bonds were taxable municipal bonds that carried special tax credits and subsidies and were pretty considered to be a big success by bond investors. In California, which is considered to be the state with the gravest fiscal concerns, about $36 billion of taxable debt was issued following the creation of this programme. This programme has been responsible for shifting about $185 billion of debt into the taxable market from between early 2009 and 2010. Now that the programme has been terminated, there seem to be indications that the bond market is bracing for long term effects of Federal governments and other issuers forgoing the opportunity to collect taxes and tax breaks respectively.

There are growing concerns that there is little in the way of a further collapse in municipal bond prices (bond prices are inversely correlated to yields). This has lead to a large number of bond indices and ETFs underperforming. The SPDR Nuveen Barclays Capital California Municipal bond ETF has seen a quarter end decline of -3.33% (ticker symbol CXA). In the face of increasing spending on things like pensions (New York City’s cost to pre fund pensions spiralled from $2,530 per full time employee in 200 to $20,333 in 2008) and healthcare (Medicaid spending went from an estimated $2 billion in 1970 to $158 billion in 2008), there seems to be little hope for a long term consolidation at current levels without more bond purchases by the Federal Reserve beyond June. This does not bode well for the American economic recovery, as the day is not far when debt reaches 100% of GDP. Although having a sovereign currency means that America will not default on its debt like the Euro zone peripherals have threatened to do time and time again (and it is indeed a fact that no country with a sovereign currency ever has), there is no doubt in my mind that in the face of increasing spending and increasing deficits, the municipal bond market faces many more defaults in quick succession than have been previously seen in their history so far.

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