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The Muni Bond Myth
Have I seen This movie before? Two years ago, analysts were predicting default rates as high as 17% for Junk bonds in the wake of the financial meltdown, taking yields on individual issues up to 25%. Liquidity in the market vaporized, and huge volumes of unsold paper overhung the market. To me, this was an engraved invitation to come in and buy the junk bond ETF (JNK) at $18. Since then, the despised ETF has risen to $40, and with the hefty interest income, the total return has been over 160%. What was the actually realized default rate? It came in at less than 0.50%.
Fast forward three years to today (has it been that long?). Bank research analyst Meredith Whitney is predicting that the dire straits of state and local finances will trigger a collapse of the municipal bond market that will resemble the Sack of Rome. She believes that total defaults could reach $100 billion. Since September, the main muni bond ETF (MUB) has plunged from $106 to $97.
I don’t buy it for a second. States are looking at debt to GDP ratios of 4% compared to nearly 100% for the federal government, which still maintains its triple “A” rating. They are miles away from the 130% of GDP that triggered defaults and emergency refinancing’s by Greece, Portugal, and Ireland.
The default risk of muni paper is being vastly exaggerated. I have looked into several California issues and found them at the absolute top of the seniority scale in the state’s obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders.
How many municipal defaults have we actually seen in the last 20 years? There have only been two that I know of. The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. And Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn’t understand sold by, guess who, Goldman Sacks. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression.
My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting. The market is currently pricing in the triple digit number.
Let me preface my call here that I don’t know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the “C” average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with major offshore institutions and foreign governments for whom the tax advantages of owning munis have no value.
However, I do know how to use a calculator. Decent quality muni bonds now carry 8% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 16%, almost as high as the peak we saw in the junk market in 2008. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.
Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.
There is one additional instructive thing that is going on in the muni market. The mayhem that we are seeing is but a preview to the real violence that we will see when the US Treasury bond market starts to collapse, possible in a few months. That I can trade, through the leverage short ETF (TBT). This is the real lesson of what is going on in muni land.
To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.
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another nonsensical piece with no relationship whatsoever to what's happening on the ground....
the teachers and police will riot? well, hello? if you raise tax rates to provide the bondholders with their pound of flesh, you'll have townspeople rioting, and then deserting the town in droves with massive defaults starting right there, let's not a talk about the states.
now that's a thought. in the past we've seen mass migrations due to war, famine, drought....can you imagine a mass tax migration?
the level of debt in the towns and states, it could happen.
I tend to agree with the dissenters on this one. The article was written from an ivory tower perspective. What do you expect from a guy who clearly wasn't a "C" student from some low-class secondary school. This is all really too far beneath him. I can say this, from my perspective (as a pension consultant), there are a number of major cities, Detroit for instance, that are in major trouble. At some point they cannot continue to kick the can down the road. There will be a bubble of retiring employees that will expect their monthly pension checks and will find out that the fund in broke. We have just entered the Baby-boom retirement bubble. This will get far worse.
As a muni credit officer at one of the top muni banks, I can verify that this analysis is spot on. This tsunami of defaults of "$100b" everyone is talking about is probably not credit defaults, but renewals of liquidity facilities for variable rate demand notes. Most municipalities want to refund using fixed rate debt, but the swap termination premiums are too high. However, if liquidity becomes scarce (as it probably will), the municipalities will just refund the VRDNs with fixed rate debt at 5.50%ish and eat the swap premiums. Their budgets will be tightened a little bit, but they will spread out the swap premiums over 20 years or so and move on. What kind of name is 'madhedgefundtrader' anyway? Commanche indian?
No, you're thinking of "Poone..." Madhedgefundtrader is Scotch-Romanian. An odd combination. As were his parents.
States debt to GDP in the 4% range? What about all of the unfunded liabilities? States will have to issue a mountain of debt to cover those shortfalls. As revenue dries up, more debt will be issued and the debt to gdp will rocket upward. Either that or the moral hazard of simply not paying...which in that case is also not good for the munis that survive. Think madhedgefundtrader missed the boat on this one.
..."Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders"...
What the Fuck?!?
...another crazy hedgie talking his book, bitchez.
Don't follow that man home!
HE'LL DRUG YA AND FUCK YOU IN THE ASS!!
unless you like that shit....