The municipal bond market has long been a place where retired folks and those in high tax brackets have sought reliable interest payments from low credit and market risk investments. Historically, very few municipal bonds or so-called muni bonds have defaulted (credit risk) and typically don’t fluctuate very much in price (market risk). Muni bonds are generally considered nearly as safe as U.S. Treasury Bonds. Until recently, municipal bond funds have had large cash inflows from investors as they sought safe, tax-free interest returns.
As last year drew to a close, many municipal bond issuers rushed many new offerings to the market to cash in on the low interest rates and to offset the expiration of the Build America Bonds, a special subset of muni bonds in which the investor income is taxable and the federal government picks up 35 percent of the interest expense. Bond prices began to decline in what was supposed to be a temporary problem with a year-end surge in the supply of new bonds.
As the new year opened in January, muni bond prices stabilized for a week or so and then started a second decline. A rout in municipal bond prices started, with many holders selling positions in what is usually dominated by long-term investors. Although the municipal bond market is nearly $3 trillion in size, the market for these bonds is spread amongst tens of thousands of issuers with tens and, sometimes, hundreds of sub issues and scales from short-term, low-interest-rate bonds to higher-interest-rate bonds with longer-term maturities. Each bond with a stated interest rate and maturity is a separate issue.
Late last year, investment analyst Meredith Whitney was featured on ’60 Minutes.’ She offered her opinion of the municipal bond market as one poised for a substantial decline in price, as well as on the edge of a substantial number of defaults, in the $100 billion range. While history doesn’t support such an event, many state and local municipal bond issuers are in serious financial trouble as a result of the recession that started in 2008 and continues right through today, despite nearly $3 trillion in stimulus from the Federal Reserve and the U.S. Treasury. Now the current stimulus efforts are coming to a close at mid-year, and the finances of the municipal issuers haven’t improved in nearly three years. Could Whitney be right? (Worth noting: She successfully predicted the collapse of Wall Street and the investment banks in 2008.) Whitney’s clients pay upwards of $100,000 for her investment analysis, and the details of her work have not been subject to review by the press, the other investment analysts or me.
Still, following Nassim Taleb’s examination of randomness in “The Black Swan,” it is entirely possible that relying on historical experience to refute Whitney’s claims might be skating on very thin ice, indeed. The developed economies have made many financial moves that just a few years ago would have seemed absurd. Yet here we are having bailed out Greece, Irish banks, U.S. banks, Wall Street, Fannie and Freddie, many states and other institutions (Penn State even got a nice chunk of change from the stimulus funds). A few days ago, Ben Bernanke took the time to emphatically state that the Federal Reserve would never use its powers to bail out the municipal bond market. Given the financially conservative nature of the new House of Representatives, it seems unlikely that the administration could mount a municipal rescue, either. Still, when push comes to shove, politicians have often come to the rescue despite prior tough-love declarations.
So we just don’t have a good handle on what might transpire in the municipal markets. Because the market for municipal bonds is discontinuous (not every issue trades every day the market is open), most pricing is done via computer modeling. Therefore, prices can best be followed by tracking a number of municipal bond mutual funds. The mutual funds are at least readily saleable, unlike individual bond issues.
Since last October, many municipal bond funds have declined more than 10 percent, a huge drop by historical standards. With the municipal issuers now having to come to grips with their budget shortfalls, it seems prudent to step away from this market for now until the financial problems of the issuers have at least started to be effectively addressed by the politicians. Yet, as we kick the financial day of reckoning down the road another couple years, the federal government could come to the rescue (Remember that another election is coming up in 2012) and my conservative notions could be wrong.
This financial drama will play out in the coming months. I’ll report what is happening and who is making the moves so that you can better determine if municipal bonds are right for you. Stay tuned.
