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.


David L. Spurr said...

This is a great post. Nobody is watching the muni market. Fundamentally.....Most states are broke, simmilar to the Federal Government. The only way for them to become solvent is to issue more debt. I expect over the next year or so a rapid escalation in muni rates. I can't see anything else happening, unless the Feds provide more incentive to want to own muni debt. Thanks for bringing this issue to everyone's attention.

Tony said...

The feds need to infuse capital where it will be utilized immediately... which has not been happening with TARP funds.

Where better to put cash to work than cities and state govts that employ hundreds of thousands and spend millions on domestic products?

I'm no lawyer, but there has to be a way to get money to these govt entities. Maybe add funding to Medicaid, road commissions, infrastructure projects, etc.

Brett Steenbarger, Ph.D. said...

Hi David and Tony,

I think you're right; the muni market has not been front and center in 2008, but is likely to become a greater source of concern in the year to come.


brbpdb said...

Vilpx does not appear to to a legitimate fund symbol--not on list at Vanguard or able to pull it up at yahoo??

brbpdb said...

brb says sorry--Vilpx is a good symbol

rcatti said...

"au contraire," though there will be some larger muni sectors under severe pressure in 2009, private deals, small municipalities, lower grade credits,etc.will suffer the most, i.e. downgrades, lack of insurers, liquidity issues, the overall muni market has yet to experience a serious drop in yields as overall credit conditions normalize and investors reach out the curve for returns. The "zero rate policy" of the FRB will act as a powerful magnet on muni's particularly as the central bank begins buing intermediate and long dated coupons in U.S. treasuries and mortgages in the new year. Expect long term high rated muni yields to head towards 3% as long bonds move towards 2& and corporate spreads collapse.

Tony said...

Since I own some Munis, I couldn't be happier if the yields drop. That's what my bet is.

Munis getting some TARP money or a fiscal infusion would be the best thing to happen.

Brett Steenbarger, Ph.D. said...


VILPX was folded into another Vanguard fund: VWLTX. Thanks--