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Municipal Bonds The Next Shoe To Drop?


Municipals are deemed to be the safety net of many portfolios and this may not turn out to be the case.


My firm was fortunate enough to side-step the sub-prime sublime and junk bond mess, and for the most part, the debacle in equities in the financial space, but that is now in the rear view mirror. When financial news makes it to the front page of my local paper, The Orlando Sentinel, I stop focusing on it because it is then fully discounted. I like to say 'What the markets know isn't worth knowing.'

So, what lies ahead? We constantly need to focus on what lies ahead, whether it is positive to identify securities to own, or potential negatives that help us avoid losses. The problem child ahead may be, deep breath, the municipal bond market. I will explain my position below.

The Municipal Bond Insurers, The Latest Bailout

Most investment problems can be quantified when leverage isn't used. A particular bond or stock can fall to zero, but the patient investor that owns the falling security can afford to wait if they are not using leverage. The initial problem with sub-prime loans was the poor quality of the underwriting standards and it should not come as a surprise that many of these loans went into foreclosure. The nature of the business cycle meant that high quality loans were made at the beginning of a cycle and the lowest quality loans were made at the end of the cycle. This cycle was no different.

The difference was when these loans were placed into Collateralized Debt Obligations, or CDOs, that employed substantial amounts of financial leverage. When the loans began to fail, the prices of the loan pools within the CDOs began to fall, which in turn forced the owners of these CDO securities (who were for the most part leveraged as well) to sell. There really is no transparent market for any of these securities so when the margin clerks came calling, the owners of these securities were forced to 'sell what you can, not what you have to.'

What could be worse than owning these esoteric securities outright? They actually created yet another CDO that buys other CDOs-this means that you are placing leverage on top of leverage on top of leverage-otherwise known as 'CDO squares.' And guess who owns a bunch of CDO squares? The municipal bond insurers like MBIA (MBI) and Ambac (ABK). I have no idea if the smaller insurers like FGIC, FSA and ACA Financial own them, but they have other problems of their own. A recent report by Barclay's indicates a likely downgrade of FGIC, which insures over $300 million in bonds.

There has been much press about a bailout of MBIA and Ambac by a consortium of commercial banks that would include a $15-20 billion cash infusion. It would be very dangerous to let all of the bond insurers fail because it may cause the municipal market to go into disarray and thus increase borrowing costs for many issuers. What bothers me is that the banks in this bailout are the same ones that have been writing down sizable chunks of book value and then, hat in hand, go to Singapore, Kuwait, the UAE and China to recapitalize themselves.

So the poorly capitalized banks that had to beg for capital are now going to use that capital to bail out the insurers, whose business models were flawed to begin with? You have got to be kidding me. This is like having a neighbor who is about to go bankrupt and asks you to bail him out, so you lever your own balance sheet with credit card advances and home equity lines to finance the bailout. This doesn't make much sense to me.

What the Markets Hate: Uncertainty

I asked a municipal bond trader friend the other day how business was going. The response was "What business? How can I place a bid on a bond that is currently insured but I have no idea what the price should be if the insurer gets in trouble? The bonds could trade down 5-10 points. So I don't bid."

My firm doesn't own any municipal bonds for clients, nor have we for a few years as I thought that the real estate mess would bleed through to the tax bases of municipalities and I didn't like the fact that the bond insurers insured hundreds of times more bonds than they have capital. I was questioned severely more than once as to why we didn't own municipal bonds, but resisted buying them because I was afraid that what we are currently witnessing might actually happen.

Municipal bond offerings continue to get priced on a daily basis as municipals do indeed look 'cheap' compared to Treasuries. Many long term municipal bonds are trading 'through' Treasuries, or rates above taxable Treasuries. For example, in the table below is a recent deal priced by Lehman for Pima County, Arizona, due in 2027 and being offered at a 4.75% yield by the underwriter (I guess they couldn't get the deal done and are stuck with the bonds in inventory) which is 110% of the corresponding Treasury yield. At a 35% tax bracket, this equates to a 7.308% 'tax equivalent yield' which is 170% of Treasuries. Are they cheap or are they a 'value trap'? Value traps are known for looking cheap, only to get cheaper. The Pima County bonds are AA rated on their own by S&P without any help from a bond insurer.

Click to enlarge.

But what about bonds that are still coming to market like Portage Michigan Public Schools that are insured by FSA? The bonds have an 'underlying rating' of A1 by Moody's and AA- by Standard and Poor's but because FSA insures them, they have FSA's AAA rating. So where did the bonds get priced? 4.31%. And guess what, those bonds are being re-offered as well. The problem here is that if FSA is stripped of their AAA rating, which I find highly likely, you had better be ready to trade the bond on its own merits.

Click to enlarge.

Note how the 'taxable equivalent yield is 6.63% compared to the 7.3% in the bond above. The Pima bonds carry a higher underlying rating but trade 70 basis points cheaper due to not being insured. This is a market anomaly that, in my opinion, won't last much longer.

If I owned a large portfolio of municipal bonds, I would do a lot of homework on the underlying credit ratings of the issuers and the stability of the issuer. If I had to own municipal bonds, I would own only 'pre-refunded' municipal bonds. Pre-re's, as they are known in the industry, are usually backed by U.S. Treasury and sometimes U.S Agency securities. The problem with pre-re's is that they are 'priced for perfection.'

Most pre-re's that mature in the 2015 area are trading with measly yields in the 2.90% area according to a search I just ran on Bloomberg for Street offerings. 2.90% equates to a tax equivalent yield of a whopping (note sarcasm) 4.46%, not exactly the kind of return I desire when I believe inflation including food and energy is running in the 6 to 7% range. Clearly the market is beginning to separate-and properly so-the bonds that are truly safe from the ones that are not. The example below is an actual offering of a pre-re that is 46% backed by FNMA, 43% by FHLB, 8% FHLMC, 2% Treasuries and 1% FFCB. I must say that this is a bond that is not attractive in the least to me when I can buy securities backed by FNMA and FHLMC (Fannie and Freddie) at higher yields.

Click to enlarge.

The market is clearly pricing in uncertainty to the bonds that must rely on insurance or their own ability to pay interest. This trend is just beginning, in my opinion.

Continued on Page 2.

No positions in stocks mentioned.

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