Sunday, December 14, 2008

Why the Municipal Bond Market is in Decline

Something interesting has been going on since the latter part of November: investment grade corporate bonds (LQD; blue line) have dramatically outperformed municipal bonds (MUB; pink line). Actually, the outperformance is understated in the chart above, as illiquidity among munis has left arbitrage opportunities unexploited, leading to mispricing of MUB relative to its net asset value. The underperformance of municipal bonds has been especially notable at the long end, as shown by Vanguard's fund (VILPX; yellow line), which is making fresh bear market lows, even as corporate bonds rally.

So why are municipal bonds--which already yield more than their taxable counterparts in the corporate world--widening their underperformance? Partly, it is a function of risk aversion, as investors flee uncertain investments and instead seek safety in the lower yields of Treasury instruments. Growing budget problems in such states as California and Michigan are also taking their toll on investor sentiment. Indeed, the flight from munis is so notable--the once safe and stodgy sector is down over 8% this year--that one money manager plainly states, "The muni market is not working normally."

Even muni issuers such as Goldman have been recommending the purchase of credit default swaps against the possibility of municipal defaults. This default fear has especially rocked the high-yield segment of the muni market, which has seen declines approximating 30%. These concerns, combined with the increased need for hedge funds to invest in the most liquid instruments, has led to a historic divergence in the behavior of munis relative to Treasuries. This weakness recently led PIMCO to suspend dividends in its municipal closed-end funds.

While automakers have gotten most the news this past week, the eroding condition of tax-free credit markets may pose graver problems for municipalities and the many high net worth investors who have sought shelter in tax-free instruments. The dynamics that have led to this historic weakness--a severe recession slashing state and local revenues and a flight of investors to safety and liquidity--show no sign of abating, and price declines continue to erode returns from otherwise attractive yields. Meanwhile, the Fed has explicitly stated that it cannot help state and local governments, and Treasury has denied access to TARP among municipalities, further heightening investor anxieties.