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Conclusion: We think any asset class that is trading just shy of all-time highs in prices without a clear outlook for continued improvement in its fundamentals is rife with asymmetric risk to the downside. 

On Friday afternoon, Keith shorted the iShares National Municipal Bond Fund (ticker: MUB) in our Virtual Portfolio. In short, the fundamental thesis behind putting on this risk exposure is twofold: 

  1. From a long-term perspective, we think muni bond yields will rise amid our belief that U.S. interest rates are poised to continue making higher-lows; and
  2. The view that municipal issuers are experiencing a structural improvement in credit quality becomes decidedly less supportive going forward, posing a risk to muni bond prices as demand from the marginal investor slows. 

Looking at muni bond prices from an average yield to maturity perspective, the Bond Buyer U.S. 40 Municipal Bond Index is currently yields 4.65%, down from a cyclical peak of 5.95% in JAN ’11. Then, the story was growing fear of default and oversupply amid an expiration of the Build America Bond program. Since then, muni issuers (particularly on the State side) have shrugged off these credit concerns and continued to strengthen their balance sheets by dramatically reducing expenditures – even amid a sharp decline in federal support.

Priced to Perfection?: Short MUB Trade Update - 1

 

Priced to Perfection?: Short MUB Trade Update - 2

Now the question going forward is: “How much better can it get from a credit perspective?” While that doesn’t imply an immediate reduction in issuer credit quality, it does imply that fundamentals are unlikely to continue improving from what is known/priced in.  As the chart above highlights, States’ need for fiscal consolidation (i.e. the “hurdle” they must clear from a credit quality perspective) has declined to at least a four-year low in FY13 and is only ~1/4th  the size of the “hurdle” that was cleared in FY10.

Broken TRADE and TREND on our PRICE/VOLUME/VOLATILITY model, the MUB etf is signaling to us that tough questions are, at a minimum, starting to be asked in this traditionally-opaque market. Tough questions, such as: “If Obama wins reelection and the Democrats do better-than-expected in Congressional elections, will the tax exemption of muni bond income come under increased legislative scrutiny as Obama looks to secure additional funding for his ‘fair share’ initiative(s)?” do pose risk to the muni market from a price discovery perspective given that muni bond prices are just shy of their all-time peak (+14bps from YTM perspective).

Priced to Perfection?: Short MUB Trade Update - 3

 

Priced to Perfection?: Short MUB Trade Update - 4

All told, we think any asset class that is trading just shy of all-time highs in prices without a clear outlook for continued improvement in its fundamentals is rife with asymmetric risk to the downside. Muni bonds fit this framework like a glove; as such, we have decided to trade around muni bonds on the short side in our Virtual Portfolio.

Darius Dale

Senior Analyst