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What Could Cause a Dislocation in the Municipal Bond Market?

When you really boil it all down in the financial markets, it usually comes down to the law of supply and demand. Prices usually rise when demand outstrips supply and vice versa. Issuance has been on the decline lately so one would suspect that demand would overwhelm supply and yields would fall, but that is not the case as the chart below suggests—there is net redemption of municipal bond funds despite low levels of issuance. This is a warning sign in my book and must be watched closely. If supply picked up again and demand didn’t surface, municipals would get cheaper: the value trap at work.


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The municipal market is a rather large, opaque market with over 1,000,000 individual securities outstanding (by CUSIP, or security identifier) by nearly 50,000 issuers and is $1.8 trillion in size. This is a large number when you compare it to other markets listed below.

• Treasuries: $3.1 trillion.
• Corporate Bonds: $4.0 trillion.
• Federal Agencies: $2.3 trillion.
• Money Market Instruments: $2.5 trillion.
• Mortgage Securities: $4.6 trillion.
• Asset Backed Securities: $1.5 trillion.
• Credit Default Swaps: $43 trillion.

I have highlighted the size of the CDS market because it is now much larger than the cash market in which it is based. I guess you can say the tail is now wagging the dog. Or to use another analogy, it is a game of musical chairs with many more players than chairs. I hope the music doesn’t stop suddenly.

The Potential Catalyst: Levered Closed End Muni Funds

As I stated early on, an investor can sit through most any quality situation without leverage. But once leverage is introduced into the equation, many times the decision to sell is made by a margin clerk. There are two other ways leverage can kill. First, if your funding is taken away from you, your ability to finance your positions can go away (this is how Drexel Burnham Lambert, a firm I worked for, went out of business: Its counterparties stopped financing them). The second way to get killed is if the volatility of the position increases. Such is the case with most of the universe of closed end bond funds.

A while back I wrote an article that described ‘the anatomy of a closed end bond fund.’ Rather than re-hashing the entire article, simply click on the link to get an idea of how closed end municipal bond funds are constructed.

In a nutshell, closed end funds buy a bunch of long term municipal bonds and then leverage them by offering weekly floating rate securities to investors as ‘money market instruments.’ The overall structure ends up with the floating rate shares representing 33% of the overall capital structure and this in turn allows the fund to lever up by 50% from its initial position. The result is a higher yield, but a more volatile yield and a more volatile share price. Since these funds trade on exchanges and only sell shares once, sentiment is reflected by the share price trading at a premium or discount to net asset value. There are currently 266 municipal bond closed end funds with assets slightly less than $100 billion.

The problem I see going forward is that if the values of municipal bonds drop, as I fear they will, the asset values of many of these funds could drop, perhaps dramatically. This could lead to a general lack of confidence in the issuance of the floating rate money market notes and lead to a forced liquidation of the funds. You can imagine selling could beget selling which could beget more selling. Another potential problem is that the floating rate money market note holders demand higher yields which would increase the funds borrowing costs, which in turn lowers the dividend paid to shareholders. In the two graphs below, you will see how auction rates have been increasing over the past couple of years for the Blackrock Muni Insured Fund (MYI) even as the Fed has lowered borrowing costs.

It seems that the train is on its way off the tracks. My firm does not own shares of any of these types of funds and is contemplating a short position for its fund. I have seen the prices of these unravel in the past, but the next unraveling could prove much more disorganized. I would not come close to owning either the auction rate preferreds or the funds. To be frank, I believe they are some of the most dangerous fixed income investments out there. When you think about it, they resemble CDOs in that they take a bunch of securities and lever them in order to generate commissions and fees for their underwriters. They are nothing more than a ‘margin account in drag.’

MYI Auction Rate Preferred Rates June 2006-Present

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MYI Auction Rate Preferred rates October 2004-May 2006

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The Potential Far-Reaching Effects of Fallout in the Municipal Market

In summary, there are a few major issues within the municipal bond space. First, holders of municipal bonds are often retail investors who have relied on the bond’s insurer and blissfully buy bonds because they are ‘AAA and insured.’ Having spent 15 years in the bond sales and trading game, I know this is the case. Many institutions do indeed look at underlying ratings before buying bonds, which is more prudent. But a serious down draft in prices could have a far reaching impact for investors.

Municipals are deemed to be the safety net of many portfolios and this may not turn out to be the case. Further, the cost of borrowing could rise, perhaps dramatically depending on the credit, causing profit margins to shrink. This will likely be a fluid market that I will look to take advantage of, possibly in both directions. I think it would be a good idea for investors to stress their holding of both individual municipal bonds, open end funds, and in particular, closed end funds.


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