Lessons from the Muni Bond Market in 2010
December 26, 2010
1) When Meredith Whitney talks about Munis, I turn down the sound.
Both in September and recently on 60 Minutes, Meredith Whitney – without giving any supporting numbers – predicted widespread municipal defaults. She forecasted $50-to-$100 billion in 2011.” We disagree and would like to debate her.
Many municipalities, local and state, just printed their third quarter in a row of rising tax receipts. In the past eight quarters, state and local governments swung a collective $115 billion in budget balance, from $65 billion deficit to $50 billion surplus (source Strategas). “State spending fell 3.8 percent in the 2009 fiscal year and 7.3 percent more in the 2010 fiscal year” said the lead editorial in the Sunday New York Times (December 26). They are making tough decisions on budgets and expenses. Our take is that not all situations can be painted with the same broad brush. The Harrisburg, PA incinerator has NOTHING to do with the Kansas Turnpike Authority. Ms. Whitney is not the only person who has been fanning flames without the facts. CNBC and the Wall Street Journal have also added to the hype. Security for most general-obligation and essential-service revenue bonds is very strong. There are difficult choices for state and local governments – and most are making them by adding forms of austerity to their budget lines.
2) The bond market can survive without bond insurance.
As little as two and a half years ago, almost 60% of new issues were coming to market with some form of bond insurance. The downgrade of most bond insurers was not because of Muni related credits. It was due to the problems of their insuring mortgage-backed securities. Right now only Assured Guaranty, which merged with FSA, is writing insurance. That 60% is down to single digits, but the market is coping. The world has learning to live with bonds rated BBB, A, and AA on their own.
3) Bond insurance is not totally dead.
Assured Guaranty continues to insure municipal bonds. Other insurers are not writing insurance because the market has discounted away their value. Both FGIC and AMBAC’s parent companies declared bankruptcy, but the insurance subsidiaries continue to insure the bonds already insured, AND the covenants that were put into place by the issuers when purchasing the insurance are also in place. As a point of interest, MBIA Inc., the parent of the bond insurer, has seen its stock price actually go up from $4 to $10 this year. Remember, the insurers are still amortizing older bond premiums and are still earning interest from their investment portfolios.
4) Build America Bonds (BABs) were a good thing.
BABs will end 2010 with approximately $186 billion in issuance. The program, which began in April of 2009, is that rare program crafted in Washington, DC that actually WORKED the way it was intended to. It provided lower financing (through a 35% Federal subsidy of the interest paid) to municipal bonds issued for SHOVEL-READY projects. While it currently has not been renewed for 2011, there is talk that a bill will be introduced in the new Congress to extend BABs, albeit at a lower subsidy rate. The existence of BABs subtracted from new tax-free supply. That put downward pressure on tax-free bond rates until this November. It also opened up the municipal marketplace to a newer and broader scope of investors: pension funds, foundations, IRAs, Keogh plans, and foreign buyers. Expanding the base of buyers of municipal debt was one of the BAB goals and it was VERY successful. To have Asian pension funds and Belgian dentists and Persian Gulf sovereign wealth funds all wanting to buy the North Carolina Turnpike authority in BABs form is a desirable outcome of the program. The United States runs a current-account deficit and needs incoming foreign capital to balance it. BABs were one way that we were filling this void – until Congress failed to extend it. We believe the program should be brought back.
What happened at the end of 2010?
The tax-free bond market is still susceptible to huge volatility swings. It is driven by the decisions of millions of American taxpayers. It is comprised of nearly 100,000 separate issues, totaling almost $3 trillion. The pricing of bonds is estimated by mathematical formulas from limited actual transactions since only a few of those bonds trade daily. The days of homogenous bond pricing off a AAA bond insurer’s rating are long gone. Therefore, the forced selling of a mutual fund into this market drives all prices dramatically down even though only a few actual trades occur. This created the highly emotional panic selling by some bondholders. It became a self-fulfilling prophesy. The media hype seized it and exacerbated it.
As the end of 2010 approached, municipal issuers thought they would need to “beat the rush” of expiring BABs authorization, so BABs issuers flooded the market. Then non-BABs issuers who were going to issue regular tax-free bonds figured that they would also have to beat the rush. The result was that all of these issuers – thinking they were being proactive – walloped the market with supply. A lot of early 2011 new-issue supply is already behind us. Many issuers are now pulling or adjusting their schedule of future deals, as they have no wish to issue debt at the present high relative yield levels. The Bond Buyer 40 yield (a long-maturity index) skyrocketed from a 4.93% yield at the end of October to 5.73% last week before making its way down to the current 5.50%. With the current taxable US Treasury 30-year bond now yielding 4.45%, we think the tax-free market at 5.5% is a terrific bargain.
To put it in perspective, when the 30-year US Treasury bond was at this yield level last May, the same Bond Buyer 40 index was at 5.08%. We are being proactive with this opportunity.
Have a great holiday and New Year.
John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland. He is a member of the Management Committee of Cumberland Advisors. His bio is found at www.cumber.com. His email is John.Mousseau-at-cumber.com.