2008 Muni Madness: The Movie

“Education is what’s left after everything learned at school has been forgotten.”
– Albert Einstein

It was that type of year in tax-free municipal bonds, as most of the assumptions that investors and portfolio managers have made for years were thrown up in the air.  We are completing a year which has seen high-grade municipal bonds yielding 200% of US Treasury yields, two episodes of massive municipal bond hedge fund blowups, most municipal bond insurers’ ratings downgraded, insurers ceasing to be a force in the market, a total collapse of Wall Street Liquidity supporting the market and, recently, massive supply.  All of this amidst the stock market meltdown and various federal bailouts.  We will review these forces at work in a market that Cumberland Advisors still feels represents a terrific opportunity in tax-free bonds.

Wall Street liquidity

We first noticed the drop in Wall Street liquidity in relation to the municipal bond market in the fall of 2007, as concerns about balance sheets and subprime exposure began.  This was the first instance of tax-free bond yields rising above longer US Treasury yields.  Clearly this liquidity situation became dramatically worse with Bear Stearns being taken over by JPMorgan, Merrill Lynch being absorbed by Bank of America, Lehman Brothers declaring bankruptcy, UBS closing their public finance department, and Wachovia awaiting absorption by Wells Fargo.  Smaller dealers have not been immune to this drop in liquidity, either.  The result has been, with few exceptions, a market which has had to rely on the bid from retail investors – which can often be very strong but which is overwhelmed in the face of hedge fund liquidations or huge supply.  Some of this drop-off in street liquidity is being replaced by some nontraditional sources:  pension funds, state and local governments, foreign buyers, and charitable foundations. None of these groups benefit from the tax-exempt nature of municipal bonds.  But the absolute cheapness of the market is attracting these buyers on a long-term total-return basis – especially when the credit quality of municipals is compared to that of corporate securities.

Insurers

The chart above shows the ratings of the various insurers at the end of 2007 and where they are now.  The drop is dramatic and reflects two main themes: (1) The rating agencies’ request that insurers raise more capital in the face of the drop-off in the market value of mortgage-backed securities that they insured and (2) the rating agencies’ opinion of a bleak outlook for municipal bond insurance in general.

The drop in market value of the mortgage-backed securities that the insurers backed has been dramatic, reflecting the liquidity of this class and, to a lesser degree, the outright default rate to date of these securities.  Many of the insurers did in fact raise capital, but not to the satisfaction of the rating agencies.  The downgrades of the insurers have also triggered covenants in certain swap agreements, requiring the insurers to post more collateral.  This has exacerbated an already troubled situation.  As for the downgrading related to prospects for the industry (cited often as a reason for recent downgrades), we feel this is in part a self-fulfilling prophecy on the part of the rating agencies.  This year has also seen Berkshire Hathaway and the Macquarie Group of Australia announce the new entry into the municipal market of a new insurer of AAA-rated bonds.  Thus these groups clearly see an opportunity (caused in no small part by the rating agencies’ downgrades of other insurers).  In any case, insurance coverage by all insurers with the exception of Berkshire, and to a lesser extent the combined Assured/FSA, has been rendered moot by the market.  Insurance is still in force, of course, but the bond market treats bonds with insurance on all but the aforementioned as if they had none and are instead pricing bonds off the underlying ratings. This process has been exacerbated since MBIA and AMBAC were downgraded by Moody’s to BAA1 early in November.

This has really created a municipal bond universe of haves and have nots.  Bonds with denigrated insurers and weaker underlying ratings have seen their market values lowered and have not participated in what has been a rally in municipals in January.  Bonds insured by Assured Guaranty, FSA, or Berkshire Hathaway have participated in this rally, but clearly high-grade bonds with AA or higher ratings on their own have performed the best.  We are now witnessing the market phenomenon of seeing issues with no insurance out-trade the VERY SAME bond issues which have insurance – though downgraded.  Thus the market is treating the existence of one of the denigrated insurers as a net NEGATIVE impact on the pricing of bonds.  This is an unusual development indeed, and we feel it represents some value.

Overall Muni Cheapness

Source: Bloomberg

We have published the above graph a number of times this year.  It shows the difference in yields between the thirty-year US Treasury bond and the Bond Buyer 40, a long-maturity index of mostly AA and higher-rated tax-free bonds.  Normally, the yield on tax-free bonds has been below that of Treasuries, for the main reason of Federal tax exemption of income.  This year has seen a dramatic about-face: blowups of municipal bond hedge funds in February, and then later in October, were precipitated by municipal insurer downgrades in February and the Lehman Brothers bankruptcy in October.  We thought the point of absurdity had been reached in mid-October, in the midst of hedge fund selling, when the yield gap between the thirty-year US Treasury and the Bond Buyer 40 reached 250 basis points.  That was eclipsed in December with the gap climbing to over 350 basis points.  The further gapping between these two markets was due to a drop in long Treasury yields caused by what we think is outright buying of US Treasuries by the Federal Reserve in an effort to lower long-term interest rates and hence mortgage rates.  At the same time, long tax-free rates headed higher through a combination of events. High-yield bond funds saw a lot of redemptions and were selling many A-rated and BBB bonds, pushing yields on those instruments much higher and dragging better-quality bond yields higher as well.  Since then there has been a dramatic about-face in the municipal market, with a vigorous price rally and drop in muni yields similar to that in October.  This has been due to a number of factors: a market realization that yields had become distended, renewed institutional buying as year-end rollover of coupons and maturing bonds combined with flows into municipal bond funds to form a wedge of demand, and the overall collapse of short-term interest rates, forcing investors in to longer-dated paper.  In addition, there was recognition that the new administration will a have a stimulus program that includes state and local governments, thus lowering some of the default concerns which had been present last December in the muni market.  Bottom line: munis, though less cheap than in December, are still a bargain, with plenty of room for price appreciation.

Looking Ahead in 2009

Source: Bloomberg

Supply has picked up recently as issuers who had the flexibility and avoided coming to market in mid to late December are lining up now that yields are less distended.  Bulges of supply should be looked upon as opportunities.  Overall supply is clearly at a higher sustained level than two years ago – and issuers are seeking access to the capital markets now that rates have dropped.

Creditworthiness will continue to be important.  General-obligation and essential-service revenue bonds will continue to garner most of the interest, and we expect it will take a while for the high-yield municipal bond market to recover.  That is more of a story for 2010.

Higher-coupon bonds (5.5% or higher) that were issued in 2008 at various times are excellent candidates to be prerefunded by their issuers when overall interest rates in tax-exempt bonds move down.  Bonds that get prerefunded to call dates in 2017-19 will have terrific upsides in price appreciation, both from the steepness of the yield curve as bonds move to being priced to their call dates, as well as the inexorable pick-up in credit quality from the defeasance in US Treasuries.  Thus, “cushion bonds” are excellent municipal investments, especially as the relative values of municipals and Treasuries move back to a more normal environment.

State and local Governments will benefit from the House stimulus package.  This includes direct aid, infrastructure programs, aid for schools, unemployment insurance payments, and an increase in Medicaid matching grants.  There is no question that state and local governments will be under pressure in 2009.  However, as Cumberland Advisors has stated before, we DO NOT believe that we are having a repeat of the 1930s depression: both monetary and fiscal stimulus are much higher and at faster response levels than in the ’30s.

Bottom line: the turmoil of 2008 has created the opportunity of 2009.

—John Mousseau, CFA, Vice President & Portfolio Manager

~~~~

Cumberland Advisors is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.

Please feel free to forward our commentaries (with proper attribution) to others who may be interested.

For a list of all equity recommendations for the past year, please contact Therese Pantalione at 856-692-6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.