Meredith Redux – One Year Later

December 19^th marks one year since Meredith Whitney appeared on the CBS newsmagazine 60 Minutes and sent the municipal bond market into a tailspin from which it took months to recover.  To recap that event:  Ms. Whitney, a noted bank analyst, appeared on 60 Minutes and forecast “hundreds of billions” in municipal defaults during 2011.  The result was a two- to three-month siege on the municipal bond market, which was already in the throes of a supply bulge because the Build America Bonds (BABs) program had expired.

As we have written previously, the first few post-Whitney months were marked by huge redemptions in municipal bond funds.

One can see that the redemptions approached hemorrhage levels in the early part of 2011.  They got LESS negative as the spring wore on, and finally began to turn positive during the fall.  It is important to note that while the mostly retail-oriented municipal bond funds were having crushing outflows, sending longer-maturity yields skyrocketing, the demand for the TAXABLE versions of the same credits (BABs) was sending BABs yields lower, as pension funds, foreign buyers, and charitable foundations scooped up the generous yields afforded by year-end 2010 BABs issuance.  This was one of the clear signs that the Whitney-led meltdown was one related to liquidity and not to overall credit concern.

One can see from the chart that the skyrocketing of intermediate and LONGER term yields that occurred due to the 60 Minutesbroadcast continued unabated through mid-January.  This, of course, correlated with the massive amount of bond fund liquidations. And then began the long trip down in longer yields that has continued until now.

What were the keys to the turnaround?

Credit

State governments recently finished the seventh consecutive quarter of rising tax receipts.  This followed five straight quarters of declines from the fall of 2008 through the end of 2009.  To be sure, many states and cities are still struggling to rein in rising pension costs, as well as dealing with the loss of federal dollars.  But many states have made deep cuts in expenses and, in most cases, budget gaps have been closed without reliance on one-time solutions.  The market dealt with the bankruptcies of Harrisburg, PA and Jefferson County, AL without seeing a backup in overall tax-free yields.  It treated these bankruptcies as “one-off events, caused by specific problems of municipal malfeasance, and not as being indicative of overall municipal health.  As we have also written, overall financial health is better at the state level than at the local level – but all levels of government have been learning how to do more with less.

Supply

The sharp decline in long-term interest rates has spurred on issuers in recent months.  However, even with robust issuance at year end, 2011 is poised to finish with under $300 billion in total municipal bond issuance, a far cry from the $433 billion of issuance in 2010.  There is clearly a greater air of austerity at many different levels of municipal government, from the state level down to towns.  Certainly, in many cases, additional bond debt is being voted down by electorates.  In addition, many issuers decided to forego issuing bonds at the very high interest-rate levels that Meredith-mania caused in the early part of this year.  And, once the Build America Bonds program expired at the end of 2010, many officials decided to forego projects that might have been financed with the federally subsidized BABs.

Demand

Again, the municipal bond mutual fund flows tell a lot of the story. Much of the bond fund selling was replaced with INDIVIDUAL bond purchases earlier in the year.  But now bond fund flow has turned positive and should show overall positive flows for calendar year 2011.  Volatility in the equity markets has caused money to be pulled from stock funds and, presumably, some of this has found its way into the municipal bond market.  In addition, the prospect of higher taxes has also pushed investors toward tax-free municipals.  Although the rise in federal marginal tax rates now looks like it might be on hold until AFTER the 2012 election, northeastern states like New York, New Jersey, and Connecticut have seen a hike in marginal income taxes, thus raising demand for tax-exempt income.  We expect more states to raise income taxes at the margin in 2012 – and, no doubt, to aim the increases at higher-income individuals.

So as we head into the last two weeks of 2011, we can look at how tax-exempt yields stack up against US Treasuries on a relative basis now and in the middle of the Meredith meltdown last January.  There is no question that munis are cheaper, on a relative basis, across the whole yield curve, particularly on the front end.  But it is extremely important to note that municipal yields have moved in the same direction (down) as Treasuries – just not as much. The Congressional squabble over the debt ceiling, the downgrade of the United States by Standard & Poor’s, and the Federal Reserve announcement of its “Operation Twist “ in September all led to drops in Treasury yields, and munis – begrudgingly, in some cases – followed along.  The muni market fought those events off, along with the Harrisburg and Jefferson County situations, and made the long trip back from the despair of a year ago.  And for that we are thankful.

Happy Holidays!

Source:
Meredith Redux – One Year Later
Cumberland Advisors Commentary by John Mousseau
December 19, 2011