Fear and Trembling In Muni Land

Wolf Richter's picture

Wolf Richter   www.testosteronepit.com   www.amazon.com/author/wolfrichter

Municipal bond investors, a conservative bunch who want to avoid rollercoaster rides and cliffhangers, are getting frazzled. And they’re bailing out of muni bond funds at record rate, while they still can without losing their shirts. So far this year, they have yanked out $52.8 billion. In the third quarter alone, as yields were soaring on the Fed’s taper cacophony and as bond values were swooning, net outflows from muni funds reached $32 billion, which according to Thomson Reuters, was more than during any whole year.

Muni investors have a lot to be frazzled about. Municipal bonds used to be considered a safe investment – though that may have been propaganda more than anything else. Munis are exempt from federal income taxes, hence their attractiveness to conservative investors in high tax brackets. Munis packaged into bond funds appealed to those looking for a convenient way to spread the risk over numerous municipalities and states. While the Fed was repressing rates, muni bond funds were great deals.

Then came the bankruptcies.

The precursor was Vallejo, CA, a Bay Area city of 115,000 that filed for Chapter 9 bankruptcy protection in 2008 and emerged two years ago. But it’s already struggling again with soaring pension costs that had been left untouched. Jefferson County, which includes Alabama’s largest city, Birmingham, filed in 2011 when it defaulted on $3.1 billion in sewer bonds, the largest municipal bankruptcy at the time [but it’s already issuing new bonds; read..... Municipal Bankruptcy? Why Not! And so The Floodgates Open].

Stockton, CA, filed in June 2012. Mammoth Lakes, CA, filed in July 2012. San Bernardino, CA, filed in August 2012. They were dropping like flies in the “Golden State.” Detroit filed in July this year, crushing all prior records with its debt of up to $20 billion. That’s $28,000 per person for its population of 700,000.

But Detroit is just a fraction of what is skittering toward muni investors: the Commonwealth of Puerto Rico. The poverty rate is 45.6%. Unemployment is 14.7%. The economy has been in recession since 2006. The labor force has shrunk 16% from 1.42 million in 2007 to 1.19 million in October. The number of working people, over the same period, has plunged from 1.8 million to 1.1 million, a breathtaking 39%.

Puerto Rico had a good run for decades as federal tax breaks lured Corporate America to set up shop there. But when these tax breaks were phased out by 2005, the companies went in search for the greener grass elsewhere. To keep splurging, the government embarked on a borrowing binge that left the now lovingly named “Greece of the Caribbean” with nearly $70 billion in debt.

That’s 70% of GDP, and for its population of 3.67 million, about $19,000 per capita, or about $64,000 per working person. And then there is the underfunded pension system. But unlike Detroit, Puerto Rico is struggling to address its problems with unpopular measures, raising all manner of taxes and cutting outlays. Not even the bloated government payrolls have been spared. Too little, too late? Given the enormous poverty rate and long-term shrinking employment, what are the chances that this debt will blow up?

Pretty good, according to Moody’s Investors Service. Last week, it put $52 billion of Puerto Rico’s debt under review for a downgrade – to junk. Moody’s litany of factors: “Failure to access the public debt market with a long-term borrowing, declines in liquidity, financial underperformance in coming months, economic indicators in coming months that point to a further downturn in the economy, inability of government to achieve needed reform of the Teachers’ Retirement System.” This followed a similar move by Fitch Ratings in November.

Alas, Puerto Rico has swaps and debt covenants with collateral and acceleration provisions that kick in when one of the three major credit ratings agencies issues the threatened downgrade. Which “could result in liquidity demands of up to $1 billion,” explained Moody’s analyst Lisa Heller. It would “significantly narrow remaining net liquid assets.”

Now Puerto Rico is under pressure to show that over the next three months or so it can still access the bond markets at a reasonable rate. If not....

Puerto Rico’s debt was a muni bond fund favorite because it’s exempt from state and federal taxes. Now fears of a default on $52 billion or more in debt are cascading through the $3.7 trillion muni market. But Puerto Rico isn’t alone. Numerous municipalities and some states have ventured out on thinner and thinner ice.

Default risks are dark clouds on the distant horizon or remain unimaginable beyond the horizon. And hopes that disaster can be averted by a miracle still rule the day. However, the Fed’s taper cacophony is here and now, and though the Fed is still printing money and buying paper at full speed, the possibility that it might not always do so hangs like a malodorous emanation in the air.

Taper talk and bankruptcies are a toxic mix for munis. Now add the lure of stocks that have become the official risk-free investment vehicle with guaranteed double-digit rates of return for all years to come. So muni-fund investors, tired of losing money, are seeking refuge in stocks. This has pressured munis further. The Bank of America Merrill Lynch master municipal index has dropped 2.8% and, unless a miracle happens, will end the year in the red. A first since 2008. Its index of bonds with maturities of at least 22 years has skidded almost 6% – though the Fed hasn’t even begun to taper.

The Fed’s easy money policies over the decades encouraged borrowing binges by municipalities and states. When the hot air hissed out of history’s greatest credit bubble in 2008, the Fed’s remedy, its ingenious QE and zero-interest-rate policies, blew an even greater credit bubble – kudos! As that credit bubble transitions from full bloom to whatever comes afterwards, the plight of muni bond funds is just the beginning.

The Fed’s policies of dollar destruction took on a sudden virulent form in 1970 – clearly visible against the Swiss Franc. And it’s still going on. When even the Swiss couldn’t handle it anymore, they too jumped into the currency war. Read.... Mother Of All Currency Wars in One Chart: Dollar Vs. Swiss Franc

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
ItsDanger's picture

I love these comments about rising interest rates and continuous printing.  That is just disaster.

Notarocketscientist's picture

What happens when interest rates spike?  All munis bankrupt - another reason the printing cannot stop

brettd's picture

What would happen if interest rates went from 2 to 4 percent?

The horror....

Gromit's picture

I used to like GOs - now I avoid them and prefer bonds supported with dedicated revenues.

SmittyinLA's picture

"Dedicated revenue". LoL

They already spent the equity, and then some, the problem with "dedicated revenue" is the  people that sell it already spent it.

Dedicated revenue is how they sell even more debt, the dedicated revenue is a "confidence" tool, a hook, like A rated and "insured".

Nobody needs "investors" to "invest" in dedicated revenue.

John Law Lives's picture

"Now add the lure of stocks that have become the official risk-free investment vehicle with guaranteed double-digit rates of return for all years to come."

Pure B.S.  Stockholders thought that in 1999.

TimmyM's picture

What is the point of this article? Muni defaults are still running extremely low. Why not quote a stat about present default rate vs. historical avg.?
Yes Detroit is high profile, but anybody with a brain knew it was coming for years. PR is a special case in that is more like quasi sovereign debt. It is a tax arbitrage for New Yorkers and it hasn't defaulted yet. Those cities in CA are a tiny fraction of one percent of the market.
This is sensationalist writing. A contrarian investor can buy solid AA 30 yr tax-exempt bonds right now that pay around 4 3/4. This is a very similar rate to the 20 yr. average. You will need to lose over 22 points on this bond in a 5 yr. horizon to underperform cash. What if we have deflation? This asset may be the best one to own.
Seems to me all the bad news is priced in.

MeelionDollerBogus's picture

This is math. It's not sensational. The numbers were shown & you can judge if other numbers must be in play or if these numbers are wrong.

AGuy's picture

"A contrarian investor can buy solid AA 30 yr tax-exempt bonds right now that pay around 4 3/4."

How do you know its really AA? Mostly likely the borrower paid the rating agencies for that AA rating. The truth is that without QE and ZIRP most Muni's would be in deep trouble.

"This is a very similar rate to the 20 yr. average"

We've blown well past a six sigma event. To think the future will look anything like the past is fools errand!

"What if we have deflation? This asset may be the best one to own."

Nope. If deflation happens 70% of the Munis would default, as tax revenue would fall off a cliff and there would be no money to service the bonds.


TimmyM's picture

If people stop paying their electric and water bills, we have a lot more to worry about than our investments.

How do you know they are AA? It is called looking at the coverage ratio. It is in the rating report. It can be calculated by reading the annual financials.

There are certain bonds out there that you can run stress scenarios on that pay in a severe depression.

Do you think the States of NC or OK or TX will default? Some issuers are limited by law in how much they can borrow. It is basically impossible for them to get in trouble. Have you heard of the different school fund gaurantee programs like those in New Mexico or Texas?

Just like anything else-if you know what you are doing, you will be fine. if you trust a broker, well-good luck.


MeelionDollerBogus's picture

for some people that IS their investments, so no, that's precisely what to worry about.
That's how big this problem has been for the last 30 years.
ring, ring : clue phone - it's for you!

Clowns on Acid's picture

Exactly...deflation will not help Munis... or USTs for that matter.

AurorusBorealus's picture

Each muni is a different animal... some safer than others (I know of a lot of big billion-dollar hospital munis that I never buy... NEVER... but everyone seems to love them-then again, I happen to know a few things about how hospitals receive their income that the people who love hospital bonds do not know).  If the Fed can keep interest rates under control, which almost everyone thinks is impossible, and prevents them from ever rising again, your munis are ok, but if rates rise, fears of defaults rise, property markets tank, and municipal income drops, there are a lot, a lot more than people realize, munis that are in serious trouble... which is why I am sure... bet the farm on it sure... that the fed will begin buying muni bonds as QE4.  So, in general, yeah.. I agree with you.. munis are a good investment... especially as people start to sell them off.

pashley1411's picture

The problem is that the implications of a PR default are obvious to the rest of the municipal bond market.  In a default, and a spike in interest rates, every dam town counselor and sewage board rentier will scream bloody murder.

Confronted with another opportunity to play hero and pad their own retirement portfolio's, our self-serving jellyfish of a political class will print up another trillion without blinking an eye; its a crisis, you know?   

Why would they suddenly grow a spine over PR?

Gromit's picture

PR needs to default quickly - chance of a bailout will reduce over time.

brettd's picture

The bailout trough is already crowded.

butchee's picture

QE(n+1) will be for the Munis.

MeBizarro's picture

Worst thing that US ever did to Puerto Rico was to keep it as a Commonwealth.  It either should have been granted independence or made into a state or annexed outright. 

Puerto Rican is in a world of trouble and there is coming back for it especially if you look at the demographics and culture of those who remain right now on the Island.  Anybody with motivation especially since '08 has left to the US mainland to seek a better life for themselves and/or their family. 

Clowns on Acid's picture

Since '08 ? Feckin NYC has been inundated with PR's since the feckin 70's. All of them still have residency here even if they did go back to PR temporarily.  Most still the same generational gov't project apartment that their grandparents were given when they arrived. Manahttan and the Bronx are full of 'em.


ebworthen's picture

Fleeing muni bonds and buying into stocks.

And when the stock markets crash again, it will be more pain and suffering thanks to the FED.

Brilliant:  kill the middle class, destroy pensions and savings, increase unemployment, and debase the currency; Happy Birthday FED.

brettd's picture

No wait, EB....

Add 15 million people to the 100 million people who are 

out there looking for a job.  Genius!

martens50's picture

Just vote for more Democrats instead of those mean spirited Republicans -- problem solved!...

Ned Zeppelin's picture

Somebody tell Mitch McConnell that Republicans are not big spenders just like the Demoncrats.

Oh wait they are, they just like to throw in a tax cut on top of the spending to further exacerbate the debt problem.

Both parties equally blameworthy and hardly any difference.

rocker's picture

Seems like M. Whitney will be redeamed yet. She was just early. 

CHX's picture

Second that. Screamed early, came late (eventually :)

CJHames's picture

She can scream any time she likes.  I'll listen.  She was one of the very few who got the crash right.

acetinker's picture

I'd be happy to make her cum, at all.  Of course she's right- and it's not really a timing issue.  This is a train wreck in progress, albeit a very slow moving train.

Clowns on Acid's picture

Sexy Whitney was right all aling. QE ^ prevented her timing from being correct. She was cool though, she switched her tune to match the Fed's and major brokers soon enough to be back on the circuit... selling her specific investment ideas. Initially she got bent over by the shills in the media, but then.....

She took it like a man.

Fuh Querada's picture

Municipal bonds are likely the next recipient of monetization under Yellen's Fed. Sh*t, they are already monetizing 200 billion a month not 85 according to Jim Willie ( see his latest Goldseek article; more mortgages and interest rate derivatives). What the f**k difference do a few trillion municipal bonds make.

Never One Roach's picture

Good article. My little local Gubmint still ouit of control despite huge deficits; Big salary increases, bonuses, new buildings everywhere......Seems they are bilking every last cent before going Belly-up.


SmittyinLA's picture

Municipal bond investors eating shit is a great idea, the people backing municipal bond investment are mal-investors "investing" in criminal invasion and Socialism, not only do they deserve to lose all their "investment" they should get punitive damages too. 


BTW "water replintishment districts" are the new sub-prime "insured guaranteed return"  

Ying-Yang's picture

What happens in Puerto Rico... does not stay in Puerto Rico

Good article!

max2205's picture

Tx or FL will annex PR....fixed

Ying-Yang's picture

Not a bad idea Max... blue water and better beaches.

fonzannoon's picture

Wolf you should have some fun with the lawsuits against UBS for stuffing grandma millie full of PR debt....on leverage!

Fishhawk's picture

Used to be when you bought munis, you were guaranteed to get your money back, and all you lost was the inflation value loss of the dollars you got back.  Now the market is waking up to the fact that with most munis, you won't get your money back, even in deflated dollars.  Whitney was exactly right, she just underestimated the power of the ponzi; the cartel can keep the balloon up for alot longer than any of us thought possible...


Clint Liquor's picture

Ponzi schemes always go on longer than one would believe possible. They also collapse quicker than one would believe possible.

MeBizarro's picture

Muni bonds aren't a 'ponzi scheme' and the fact remains Meredith's call in '09 was spectuarly wrong.  You can red arrow me down all the way you like but anyone who tried to trade on her advice took a beating. 

MeelionDollerBogus's picture

it's what you DON'T trade on good knowledge that saves money - money that isn't lost is still there.
By that measure many of us kept a bundle so made a bundle.
Whitney was 100% right.
I'm sticking with that and zero muni bonds will burn me. Period.

Ned Zeppelin's picture

Timing off, her prediction was right.

She underestimated the power of the Fed printers.

Clint Liquor's picture

By definition, if you are paying interest or dividend to one bondholder with the investment funds of a new bondholder, it is a PONZI!

John_Coltrane's picture

Or, to quote a famous bankster saying (from the 1930s?),

"A rolling loan carries no loss"

MeBizarro's picture

Whitney Meredith wasn't anywhere near correct on her prediction regarding munis and anywhere close and anyone who followed her advice took a beating.  She's very bright but it was a horrendous call in regards to the specific timing and degree.   

She is right on the general outlook though for a number of municipalities over the long-term though especially when you consider their unfunded liabilities (especially healthcare for their retired workers) and the mix of their taxable base especially if they have a ton of non-profit businesses and gov't agencies that own property. 

It is going to be more of a slow-speed car wreck which is exactly what happnend in Detroit.  Simpletons and those with a political axe to grind will say it was some specific event or group that caused what happened in Detroit.  Closest thing you can get to is the '68 riots and if you are trying to tell me that something occured in '68 is the direct and immediate cause for something that happened in 2013 I would laugh in your face. 

Chuck Walla's picture

Coleman Young was the result of the riots. Years of graft and public union playoffs followed. Also, Coleman fomented an "Us vs Them" mindset agin white folk. The black leadership consumed the wealth left to them and here we are.

Freddie's picture

No she was right.   Since she made that prediction - hundreds of billions have been funneled into these cities, if they are Dem, to prop them up.   She had no idea they would print forever.  She probably even thought the ratings agencies might do their job.   Seems like when the ratings agencies do try to do their job - the SEC and FBI are called.  This insures the ratings agencies are thinking right.