Conclusion: The $2.9 trillion municipal bond market is poised to make headlines and rattle global financial markets in 2011. Keep this threat front and center on your “white board” of interconnected risk.
Position: Short Muni Bonds via the etf MUB
Quite frankly, it amazes us at Hedgeye how little attention investors are paying to interconnected risk over the last 2-3 months. While the trajectory of US economic fundamentals over this time frame can be debated, we don’t see any signs of abatement in some key domestic risks playing out literally right under our collective noses.
Housing Headwinds, originally introduced back in 2Q10 by Josh Steiner, our Managing Director of Financials, continue to matriculate. US housing prices are declining at an accelerating rate in 3 of the 4 indexes we track – even from depressed levels of comparison. We expect something in order of 15-20% further downside by year’s end.
Identifying the interconnectedness of this risk as it relates to the muni bond market leads us to another interesting chart. Local Government Property Tax Receipts grew +7.7% YoY in 3Q10, the second consecutive quarter of growth. Since their tax assessments and property appraisals operate on a ~3YR lag, this trend is not sustainable, as State & Local Property Tax Receipts correlate positively with a 0.97 r² to the S&P/Case-Shiller Home Price Index when lagged three years.
Given that local governments collect roughly 97% of all Property Tax Receipts, representing ~26% of their revenue, we smell trouble on the way for already-strained municipal budgets. Further exacerbating budgetary headwinds is the accelerating amount of fiscal austerity going on at the State and Federal levels, roughly 30% and 4% of municipal government revenues, respectively.
Since January 1st (LESS THAN TWO WEEKS), we’ve seen a drastic amount of fiscal conservatism and budget-slashing proposals at the State & Federal level. Some highlights include (not at all limited to):
- FEDERAL: $100B in spending cuts proposed by House Republicans from non-defense, discretionary spending;
- CA: $12.5B in spending cuts proposed by new Governor Jerry Brown which targets: $1.7B in healthcare, $1.5B in welfare, $1.4B in public universities and community colleges, 10% of all employment costs – each with the intention of approval by March; Additional proposal pushing an extension of 2009’s “temporary” tax increase ($9.3B); Recently ordered the recall of ~48k government-paid mobile phones, which could save ~$20M;
- IL: Just passed a +67% income tax increase, upping the State income tax rate to 5% from 3% through 2014;
- OH: Pushing legislation that would ban strikes by public school teachers and a proposal to prevent State-financed social workers from forming unions;
- NJ: Proposal to undue a 9% pension increase which was enacted in 2001;
- NY: Proposal to save $200-$400M by implementing a one-year freeze for State workers and a proposal to cut $2.1B in Medicaid outlays in FY12;
- TX: Plans to cut $4.3B from spending on education and health & human services; and
- WI: Pushing legislation that would prevent public sector employees from forming unions and bargain contracts.
Just last week, House Budget Committee Chairman Paul Ryan (R. WI) had this to say on the prospect of a Federal bailout for a distressed States:
“We are not interested in a bailout… Should taxpayers in frugal states be bailing out taxpayers in profligate states? Should taxpayers in Indiana, who have paid their bills on time, who have done their job fiscally, be bailing out Californians, who haven’t? No, that’s a moral hazard we are not interested in creating… If we bailed out one state, then all of the debt of all of the states is not just implied, it’s almost explicitly put on the books of the federal government.”
In all reality, the likelihood of the Federal government having to bail out a US State in this fiscal year or the next is extremely low (no disrespect to Meredith Whitney, who is calling for 50-100 “meaningful defaults in 2011 on the order of “hundreds of billions of dollars”). In fact, no State has defaulted since Arkansas did back in 1933.
Where this hard line on future aid really impacts the US economy is at the municipal level, where both State aid and Federal support are running dry after two years of stimulus spending. Given this headwind and the upward trajectory of interest rates, we do believe there is a substantial risk for a meaningful amount of local governments and local authorities to default or declare bankruptcy in 2011. By meaningful, we mean enough to make negative headlines and rattle the US debt market, which has far-reaching implications beyond that.
According to Chapman & Cutler, as Chicago Law firm, only five municipalities sought bankruptcy protection in 2010 (-50% YoY), with the largest being a South Carolina toll road restructuring $300M. We are essentially witnessing (with some ignoring) the calm before the storm. It’s important to note that we don’t think all municipal issuers are created equal; there will certainly be a dichotomy formed amongst issuer credit quality – much like there is in Europe’s Sovereign Debt Dichotomy (PIIGS vs. Germany, Sweden, and Norway).
In light of the Municipal Debt Dichotomy, some of the biggest buyers of municipal debt (including Berkshire Hathaway, Liberty Mutual and Allstate Corp.) have been using the current “calm” as an opportunity to decrease their exposure, unloading muni bonds to some investors who view the 5.67% average YTM as “an excellent source of yield” and “a terrific bargain”.
When it all said and done, everything has a price. What makes this game fun is figuring out what that price will be at the end of a specified duration. Over the intermediate-term TREND, we at Hedgeye think muni bond yields are poised to continue their upward trajectory at an accelerating rate in the face of material deteriorations in their fundamentals. How much this shakes global financial markets is a question we will attempt to answer each day along the way.