“A bargain is not a bargain if it remains a bargain.”
-Martin J. Whitman
Conclusion: Muni bonds are cheap again. They’re likely to get a lot cheaper. Don’t buy the dip or the storytelling that this is a “great buying opportunity because 2011 will be a great year for muni bonds”.
Position: We remain bearish on muni bonds and have traded the etf MUB in the Hedgeye Virtual Portfolio.
The quick answer is a resounding “NO”. Just ask anyone who bought U.S. equities during late-2007 if they got a great deal.
We have been quite vocal YTD regarding our bearish stance on Municipal Bonds and we foresee the proverbial “X” hitting the fan in 2011. This note is more of a strategy update, however. For a complete listing of relevant reports regarding the 2011 outlook for muni bond fundamentals, please refer to the bottom of this note (email us if you’d like to see a copy of any/all of the reports).
This view is in stark contrast to the recommendations of a quite a few large sell-side firms, who think now is great time to buy muni bonds, as they are on sale. Inconsequently, they also happen to be some of the largest underwriters of muni bond issuance, whose motivations for making recommendations are questionable at best.
Moving back to the meat of this report, I can’t help but find similarities to the current state of the muni bond market to the S&P 500 in late 2007. Muni bonds have been routed since early November and yields and credit risk have backed up materially:
Credit risk, as measured by the Markit MCDX Spread (a measure of muni bond CDS) backed up 35bps week-over-week, closing at 208bps.
The recent rout in the $2.9 trillion muni bond market is the direct result of a confluence of three factors:
- Inflation, inflation expectations and bond yields (all on a global basis) dragging U.S. Treasury yields higher (we have no one to blame other than The Ber-nank);
- Oversupply from a glut of year-end issuance ahead of the potential Build America Bond Program expiration (scheduled for 12/31); and
- Accelerating muni bond fund redemptions as retail investors who have been stuffed with bond allocations in their 201(k)’s rush to avoid more red ink on their monthly statements.
The latest moves in the muni bond market have many nervous investors and underwriters coming out of the woodwork touting things like, “Muni bonds are an excellent source of yield in a low-yield environment”, and my personal favorite: “The current weakness in muni bonds presents an excellent buying opportunity as the year-end supply glut will shrink heading into 2011.”
Below we tackle each of the aforementioned factors for muni bond weakness individually:
Bond Risk (inflation, sovereign debt, etc.) and Yields:
We see that U.S. Treasury yields have indeed been dragged up alongside global bond yields and yields across the entire curve are in a Bullish Formation (i.e. U.S. Treasury prices are in a Bearish Formation):
Apparently bond market risk doesn’t occur in a U.S.-centric vacuum filled with conflicted and compromised U.S. CPI reports.
In trying to get ahead of a potential expiration of the BAB program, States and municipalities borrowed roughly $55.6 billion in November – the most since at least 2003 – and another $53.7 billion in October – the second most on record. While 30-Day visible supply has backed off its five-year high reached on November 16th of $26.3B, the average 30-day visible supply for 4Q10-to-date remains well above historic averages for the fourth quarter:
Currently, it appears unlikely that the Federally-subsidized BAB program will be extended, as it has not been included in the recent comprise President Obama struck with Republicans over extending the Bush Tax Cuts in exchange for spending concessions for the hardest-hit American families. Amendments may be added to the bill in a vote today, but it grows increasingly unlikely that any amendments will receive support from the two-thirds supermajority needed to be passed.
The outlook for extending the BAB program grows even dimmer if the debate carries on into 2011, as the new Republican leadership is expected to continue party’s opposition towards extending the program. Since their April ’09 inception, BABs have accounted for ~23% of municipal bond issuance ($181 billion), so the removal of this program (beloved by issuers, investors and underwriters alike) will likely force an acceleration tax-exempt bond supply in 2011.
Lastly, muni bond fund redemptions have created a self-perpetuating cycle of price declines, as investors withdraw funds and fund managers are forced to sell assets to cover redemptions. In November, Municipal Bond funds suffered their first net outflow in 22 months – a whopping $7.6B!
By comparison, November’s $7.6B withdrawal is 7.2% of the $105B of net inflows added from January 2009 through October 2008. Moreover, the $7.6B redemption is roughly 4x the amount retail investors withdrew from stock funds and 5x the amount withdrawn from bond funds during the month.
Even Bill Gross saw his Total Return Fund suffer its first withdrawals in two years (-$1.9B) in November. By the looks of it, his plea for investors to load up on “Big Apple” debt won’t be enough to stop redemptions from leaking through the crack in the bond fund reservoir. On Monday, muni bond holders sought buyers for $1.1 billion in debt – the second highest single day total since December 9, 2008.
If mean reversion has its way, there’s a potential $97.4B of withdrawals waiting to be reported over the next couple of years. The timing of which is particularly important to note, as the likely extension of the Bush Tax Cuts over that duration does indeed reduce some near-to-intermediate term demand for tax-exempt muni bonds.
Conclusion & Recommendation:
When it comes to muni bonds, institutional investors are the “Odd Lot” with respect to behavioral finance. Retail investors own 70% of the total amount of muni bonds in circulation through direct and indirect holdings (mutual funds, etc.). Keep that in mind the next time you hear a sell-side recommendation to buy muni bonds right here and now. Perhaps we institutions should follow them into cash (retail investors added a net $24.7B into money funds in November – the most since January 2009).
All told, we are making an explicit recommendation with regard to muni bonds: don’t buy the dip; don’t buy the hype; don’t buy the storytelling around how cheap bonds suddenly are. They are likely to get a lot cheaper before we find real value – a lesson well-taught by Marty Whitman. That, however, doesn’t mean there will be an absence of head-faking rallies along the way.
Getting Up To Speed
With the struggles of State & local governments making more and more news of late, we’ll continue to remain diligent in keeping you appraised on this topic. We’ve written extensively on State & local government fiscal headwinds YTD; email us if you’d like to receive copies of any/all of the following reports:
February 24: DOMESTIC PIGS – A recent release by the PEW Center on the States shows a $1 trillion gap between the $3.35 trillion in pension, health care, and other retirement benefit-related liabilities currently on States balance sheets and the $2.35 trillion in assets they have to cover them. While we are not calling for the U.S. to default on its sovereign debt, the likelihood of a State and/or local government defaults may potentially lead to a downgrade in the U.S.’s credit rating.
April 20: GOVERNMENT’S MARKING TO MODEL – Property tax rates and property tax receipts continue to rise in the face of a weak domestic housing market, showing just how much the government marks their “assets” to model. We break down the convoluted municipal property value appraisal system and highlight the oncoming headwinds to local government property tax collections in the coming years.
July 21: IN A SORRY STATE INDEED - Waning federal funding, slowing tax receipts, and declining home prices will put additional strain on State and local government budgets, which have an incremental negative effect on the U.S. economy at large.
September 13: BREAKING DOWN MUNI BONDS – We firmly disagree with the relative “safety” of muni bonds, as current yields are at a disconnect with the underlying negative fundamentals that will begin to reveal themselves over the next 2-4 quarters.
October 13: CONTRACT FOR AMERICA: EVEN SLOWER GROWTH AHEAD? - Careful analysis of State & Local Government fiscal headwinds suggests that a Republican takeover of Congress may lead to decisive spending cuts, which could negatively impact U.S. economic growth in the intermediate term. Furthermore, State and Local Government’s FY11 revenue projections are very out of line with economic reality, which suggests further cuts are on the way. In this report, we analyze this divergence in great depth.
November 16: REPUBLICAN HEADWINDS FOR STATE & LOCAL GOVERNMENTS - The Republican landslide in the recent election all but guarantees State & local government fiscal headwinds will continue to materialize in 2011. These headwinds will likely result in material spending cuts and tax hikes going forward, which will create a drag on the economy going forward and increased risk for State and local bond defaults.