Becky Quick is Rockin’. Is There a Muni Selling Climax?
January 26, 2011
David R. Kotok
Becky Quick is rockin’. These days, early morning ablutions are interrupted whenever CNBC’s Worldwide Exchange and Squawk Box are doing interviews on the Muniland turmoil. Becky, kudos, you are on it! Nicole, you rocked, too.
In our previous missive “Muni Madness and CNBC Squawk Box” (January 21, 2011) we cited the interview with Thomas Doe. During that segment, Becky noted how the AAA state GO scale had traded through a 5% yield. Let us probe this number since it is one of the indicators that there is a selling climax in Muniland. That’s right: a selling climax in municipal bonds.
First a quick digression. When we see selling climaxes in stocks, they can be easily identified. Leading up to a climax, stocks fall and the price decline accelerates. Then it reaches a panic, and one can track it by the price changes on a minute-by-minute basis. The bottom is usually formed when the last emotional seller capitulates to fear, panics, and then dumps at the market. We saw this in March 2009. We saw it on “Black Monday” in 1987. We saw it when the NASDAQ crashed in 2001. Astute observers saw it at the onset of the Iraq war in 2003, although it was only visible in the European markets and in the futures prices of US stocks. When the war started in 2003, the Dow fell by about 600 points as measured by the London futures market. Within hours, the US had achieved air superiority, and the market fall reversed. American forces dominated Iraqi air space by the time the US market opened at 9:30 AM New York time. Therefore, if you look at the trading in the US, you will not see evidence of a selling climax. If you look at the trading in London in the futures market the same day, you will observe a 600-point Dow fall and intraday reversal. That was a selling climax in stocks.
Back to Muniland.
Climaxes in bonds are not as easy to see. Muni bonds trade in a dealer market. Moreover, dealers have limited capital to support inventories in this post-crisis period. Therefore, Munis are very volatile.
In a dealer market the inventory can be marked up or down without any trading. The manager of this inventory in each firm determines the price he wants to use to buy or sell and can change it at any time. Therefore, when there is selling pressure the dealers just mark down their bids. Alternatively, they refuse to bid by saying “pass.” The reverse is true when prices are rising sharply.
So, media hype by Whitney and others triggers inventory marking up –or down. Forced selling from mutual funds exacerbates the volatility. Pricing references then seem to make no sense.
When Becky Quick reported that the AAA state GO scale was above 5%, she demonstrated an indicator of a climax in Muniland. This composite is of the highest-grade states. No California or Illinois here. AAA is Utah, Virginia, Delaware, Maryland, North Carolina, and others. Think about it: AAA states, tax-free trading above 5% when the US taxable treasury is closer to 4%. That only happens in a tax-free Muni selling climax when a mutual manager MUST raise cash to pay redemptions by selling his most liquid bond.
Another indicator of a selling climax is in comparative spreads. Take two bonds that are nearly identical as to issuer, structure, and security of the pledge that makes them creditworthy. If you see anomalous pricing behavior, you are witnessing signs of a climax. In the list below, we compare a tax-free Muni vs. taxable BABs. The only real difference between the bonds in each pairing is the federal income tax code. We know the tax rate is 35%. Unlike Meredith’s generalizations and assertions, we offer the actual description of the bond that we hold and the CUSIP number so each reader can check our facts. These are live prices from last week. The pricing is the yield to worst (maturity). Remember, the tax arbitrage is supposed to be 35%.
NJ State Turnpike – A3/A+/A, BABs 7.4% 1/1/40 – 646139W35 – pricing @ 6.55%, tax-free 5.0% 1/1/36 – 646139X59 – pricing @ 5.55%. Tax arbitrage was only 18%. At full 35% tax arbitrage, the Muni would price to yield 4.25%. That is a sign of a selling climax in the Muni.
North Texas Municipal Water District – Aa2/AAA, BABs 6.01% 9/1/40 – 662903MH3 – pricing @ 6.20%, tax-free 5.0% 9/1/38 – 662903JH7 – pricing @ 5.41%. Tax arbitrage was 15%. At full tax arbitrage, the Muni would yield 4.03%. Climax indicator?
MD Washington Suburban Sanitation District – Aaa/AAA/AAA, BABs 5.0% 6/1/28 – 940157RG7 – pricing @ 5.85%, tax-free 4.0% 6/1/28 – 940157SC5 – pricing @ 4.76%. Tax arbitrage was 22%. At full tax arbitrage, the Muni would yield 3.8%. Climax?
The tax arbitrage test in Muniland is at an extreme. At a 35% federal rate, the entire curve of Muni yields from 3 months to 30 years is higher than treasuries. In fact, this is true when tested at the 25% tax rate. Such a comparison is extraordinary and rare. Climax?
Mutual fund redemption rates are a key indicator of Muniland selling climaxes. Ned Davis Research’s excellent databases help us. Redemption rates of 2% mark previous climaxes. In this selling rout, we have exceeded that level. Net outflows from Muni funds are at a record. $4 billion last week is an all-time high. Other measures of the decline in Muni prices during the last three months also set new records for the history books. These are all signs of a climax.
Who is selling and who is buying? This, too, helps define a climax. The statement is usually characterized as assets moving from weak (unsophisticated and unskilled) to strong hands. Again, we thank Ned Davis. Households and mutual funds each hold about a trillion in Munis. They have been the sellers. Banks and Insurance companies have been the buyers. So have we and our clients.
Lastly, we must note that a climax and the subsequent turn are usually marked by a firming of market prices in the midst of bad news. Wall Streeters call it “climbing a wall of worry.” We think the climax extreme day may have been the freefall pricing of last Wednesday. Two days later, the media hyped this cockamamie political scheme to amend the federal bankruptcy law so sovereign states can avoid payment. Oh, what wonders spring from the fevered brows of our politicians! Is this the ultimate stupidity in a proposal? Ugh!
Markets have actually rallied in the face of the news. They realized that such a law would raise the entire cost of financing for every state and every local government. Since the announcement we have seen governor after governor say, do not do it. Congressional representatives are speaking out against it, too. Thank you Eric Cantor. The Illinois State Treasurer opposed it. Thank you Carl Quintanilla and Becky Quick for the Squawk Box interview with Dan Rutherford. And S&P state rating specialist Robin Prunty clarified the states’ condition in detail. And thanks to Worldwide Exchange’s Nicole Lapin for bringing Delaware Governor Jack Markell on for a full hour. Readers may find those interviews helpful. Search under the names on CNBC.com.
And, last but not least, thank you Meredith Whitney. You made a good call on banks. That is to your credit. Then you segued into economics and forecast a 13% unemployment rate. We haven’t seen that yet. Maybe CNBC can find that tape and replay it. And now you forecast “50 to 100 large defaults,” measured in the 100s of billions. Nope. We doubt we will see that either.
In our view, the media hype has presented the Muni buyer with one of the classic selling climaxes in Muniland, and they do not happen often. Investors can panic, sit tight, or buy. We have been buyers.
Finally, we get lots of email. Many smaller investors ask what to do when they don’t have enough money to engage professional research and get help to determine which bond to buy. This is a very fair question.
Answer: go with what you know and understand. Look around at your town and county and school board. Choose a name that you can identify easily and where you can understand the municipal business model. The NJ Turnpike is a key example. It simply has a government monopoly position on a toll road that goes from New York to Wilmington Delaware. Try and drive it without using the Turnpike. Those tolls secure the bondholders. FHA- and VA-backed mortgages support the North Dakota Housing Authority. Water revenues pay off the bonds of the Cleveland water utility, and on and on and on. There are 90,000 idiosyncratic, publicly available, tax-free municipal bond issues. The facts are transparent for anyone willing to do the work to find them out.
Meredith and others have given the tax-free bond buyer one of the great entry points in modern times. It doesn’t get much better. All the signs and indicators are aligned. That is what a selling climax is all about. In stocks it was in March, 2009. In Munis we think it is January, 2011.
BUT if you think the world is coming to an end, if you think that all these bonds will default, if you believe the media hype, then don’t buy them. Put your money in the bank and earn a lousy fraction of one percent in taxable interest. Stock the cave with canned food and bottled water and ammunition.
David R. Kotok, Chairman and Chief Investment Officer