This note was originally published at 8am on January 28, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“No snowflake ever falls in the wrong place.”
- Ancient Zen Proverb
Both the title of this morning’s Early Look and the quote above are very apropos for the current weather gripping New Haven, CT and much of the northeastern United States. Though the mounds of snow which line our streets are several feet high, it’s “business as usual” for those of us who refuse to blame our disappointments on things like “the weather”.
Addressing the quotation specifically, the saying above traces its origins to Zen, a school of Mahayana Buddhism. Per our friends at Wikipedia, what distinguishes Zen from other schools of Buddhism is its search for enlightenment through self-realization in Dharma practice and meditation rather than a reliance on text and intellectual reasoning.
In the asset and risk management industry, an overreliance on intellectual reasoning can get us into trouble, as we often lean towards the conviction we receive from our data analysis and channel checks versus what may or may not be blatantly obvious. In fact, we’ve all been trained to fade the obvious – even sometimes to a fault.
This brings up an interesting topic that is gathering momentum in the marketplace: Muni Bonds. The divergence in sentiment between retail investors and institutional investors seems to get wider by the day, as one group (retail) rushes to avoid what is perceived by some to be a pending crisis while the other (institutional) finds current valuations as a definite reason to “fade the obvious”:
- Yesterday, it was reported that retail investors withdrew an additional $1.9B out of muni bond mutual funds. Though down from last week’s record $4B redemption, the trailing four-week average increased slightly to $2.3B. All told, the last eleven weeks saw a cumulative outflow of $22.5B, according to Lipper FMI. That’s ~22.5% of the roughly $100B poured into the funds from January 2009 – October 2010. Yes, there’s another side to the Bush Tax Cut extension trade…
- Amidst the selling by retail investors, asset managers have used the latest backup in yields as a buying opportunity to lock in exceptional tax-adjusted rates, sending average yields on G.O. muni bonds down (-16bps) wk/wk, as measured by the Bond Buyer 20 Index. To a lesser extent, revenue bonds were bid up as well, with yields falling (-5bps). This was the first weekly decline in muni bond yields in four weeks.
To state it bluntly, we don’t see current prices for muni bonds as an investable opportunity to “fade the obvious”. We’re neither brave nor smart enough to get in the way of a potential wave of defaults, restructurings and credit downgrades (emphasis on potential, as we disagree with Whitney that $50-$100B worth of defaults is a foregone conclusion). You don’t need defaults for the price of a bond to go down.
Even for those brave investors who possess the analytical firepower to find value in the muni market at current yields – including the highly-regarded Lyle Fitterer – we think many of them may actually be using faulty data in their analysis. Fitterer, the top muni bond fund manager of the last decade, remarks, “The baby has been thrown out with the bathwater”; as such, he’s using the current back up in yields as a buying opportunity for specific revenue bonds.“If a State were to file bankruptcy, I have a bond with a dedicated revenue stream,” he says.
Fitterer’s comments beg the question, “What’s a revenue bond worth when it doesn’t meet its revenue target?” Probably the same as an equity that misses estimates amid bullish sentiment: less. While we’re not yet calling for a spate of “misses” across the nation, we do think the confluence of slowing domestic growth, rising interest rates and a rapidly deteriorating housing market will weigh heavily on the finances of States, municipalities and municipal authorities alike in 2011:
- Consistent with our Consumption Cannonball theme, we expect consumer spending to roll over in 1H11. Sales and income tax receipts combine for ~55-60% of State and local government revenues. Deteriorating fundamentals = bad for muni bonds.
- Consistent with our Trashing Treasuries theme, accelerating inflation on the strength of a Debauched US Dollar continues to support rising US Treasury bond yields. The Ber-nank may not see inflation, but the global bond market sure does. A rising interest rate environment = bad for muni bonds.
- Consistent with our Housing Headwinds Part II theme, we think US housing prices could end up down (15-20%) by the time the July 2011 Case-Shiller data rolls in (early fall). Property tax receipts make up roughly 26% of local government revenues, though they are typically assessed on a 2-3 year lag. Regardless, municipalities across the nation are running out of headway to finagle with their accounting. US housing wasn’t exactly robust over the last 2-4 years. The oncoming wave of lower property tax receipts = bad for muni bonds.
Speaking of borderline accounting fraud, a very alarming trend has emerged over the course of the most recent economic downturn. Rather than lie about their deteriorating finances, a growing number of municipalities have opted to hide them instead.
A recent study done by DPC DATA Inc. revealed that over 56% of municipal issuers did not file a financial statement in any given year between 2005 and 2009. Over 33% of them skipped filing in three or more of the past five years. In the latest year (2009), the percentage of non-filers jumped +360bps to 40.2%. An additional 30% filed “extraordinarily late” that year, according to the analysis.
It’s tough to analyze what you can’t see. Moody’s Managing Director of Public Finance, Robert Kurtter, agrees, saying on CNBC’s Squawk Box that 2/3rds of all muni issuers are unrated (1/14). And even if they we’re “rated”, we’re not buyers in blind faith of America’s ratings agencies!
Regardless of your perception of the fundamentals, the “snow” is falling in the muni bond market and the thick coat of snow accumulating serves as a metaphor for the opacity that’s associated with issuer finances. When the ice melts in the coming months, will you be holding a bag full of “unforeseen” risk because you bought the first dip after a 30-year bull market in muni bonds? We definitely won’t be – that’s for sure.
Remember, no snowflake ever falls in the wrong place.
Darius Dale
Analyst
