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  • Municipal Bonds

    Posted by Carl from Chicago on January 10th, 2011 (All posts by )

    In general the investing thought process on risk is:
    – US government debt lowest risk (and CD’s)
    – then municipal debt, which rarely defaults (often the “nominal” interest rate offered is lower than the Federal rate because it is tax exempt, for the most part, but the “effective” rate is higher)
    – then stocks

    All things being equal, you’d expect to have a low interest rate on US government obligations (now short-term it is effectively zero or less than 1% unless you go out a couple of years), a modest rate on municipal debt, and then the return on stock prices is a component of the rise in prices (generally expected to be about 10% over time by most commentators) plus dividends (and the growth in dividends).

    What people are starting to notice, however, is that municipal debt “earns” that higher return than the Federal instruments by being riskier. The New York Times (which has an excellent business section) had an article titled “Gauging Those Tremors in Municipal Bonds” on January 9, 2011:

    (the) benchmark muni index lost 4 percent in the fourth quarter, nearly a year’s worth of income yield for an intermediate-term, high-grade tax-exempt bond fund.

    Meredith Whitney recently raised her profile in the media by going on “60 minutes” and describing how we are going to have a “Day of Reckoning” for state budgets. Side note – gotta love Wikipedia – I would have never known that Meredith is married to a former pro wrestler.

    I would say that, in general, the nation was taken aback by the fall in home prices and now people have a grim understanding of how the housing market really works. An acquaintance of mine recently said he couldn’t re-finance his home because he didn’t have enough equity in it; and he purchased it in 2002, far from the frothy 2007 at market highs. In the 90’s and up to the mid 2000’s the average person also believed that the stock market could give them 10% returns over time; we have spent the last decade or so essentially flat. Anyone retiring soon or looking at their statement also has seen that the common wisdom isn’t paying the bills.

    So I would say that the public will likely awaken sooner to the issues with municipal debt sooner than they did to these other asset class issues. It is strange to say that there is an asset class “bubble” but in some sense there is with municipal bonds because they are able to sell them with such a small risk premium (only a bit above the Federal risk free rate) while they, in fact, have been storing up a great deal of risk.

    While the “professional” indicators are seeing red (CDS rates by state), there are new “measures” being tossed about by commentators attached to the status quo (pretty much everyone in government and the muni-issuing community) showing statistics such as “debt to GDP” with the states around 5% while the Federal government is > 70%. The difference is that the crisis at the state level is laid bare; you can’t go to California now and say that there isn’t a debt crisis or in Illinois either; the state of Illinois is not paying bills nor have they made contributions to the states’ massively underfunded pension plans – and the only place they can go to are the state tax payers who emphatically are not excited about putting more money into such obviously un-restructured institutions.

    If you have money in municipal bond funds you are subject to many other items driving change than the credit worthiness of the main issuers; you have benefited from the Fed’s policy of dropping interest rates to nearly zero and the Federal governments’ cash infusions into the states as part of the stimulus package. Both of these tides are likely to recede at some point, as well.

    In the vast universe of municipal bonds there are huge differences in credit-worthiness and if you select individual bonds and hold them to maturity you won’t face the same issues that the bond funds face, above. However, the fact is that municipal bonds are traditionally priced as if the likelihood of default is remote and over the next few years we will see if, in fact, that is true. If you are holding municipal bond funds, especially those with concentration in risky states (pretty much any state run by a “blue” party right now), you are in effect betting that these defaults are remote and that no risk premium is warranted.

    Good luck.

    Cross posted at Trust Funds for Kids

     

    5 Responses to “Municipal Bonds”

    1. The Kid from Bristol Says:

      The linked article from the NYT is almost identical to another article, also in the NYT, from about 3 years ago. Except that they were discussing collaterized mortgage obligations rather than municipal bonds. There was the same parade of “experts” from various interested parties who described the historically low default rate, probably around the same 0.3% quoted in the linked article. Conservative as they were, they predicted perhaps a tripling of the rate to perhaps 1%–certainly nothing to be alarmed about.

      Readers of this blog are aware that they were off by more than an order of magnitude, and the resulting tremors, that almost wrecked the world’s economy, have not yet fully abated.

      Carl, what makes you say that NYT has an “excellent” business section? Unless you mean that it is excellent in spewing the conventional wisdom, that is usually wrong, and leads the gullible to ruin.

    2. tehag Says:

      ” I would have never known that Meredith is married to a former pro wrestler.”

      Should make her or his autobiography worth reading. I can’t say I’ve even met a pro wrestler or a newscaster.

    3. Joseph Somsel Says:

      Is there a way to short muni bonds? Pick a city, say Chicago or Detroit, and bet against them making interest payments or being redeemable at maturity?

      Of course, when an investment class suffers from a few bad actors, well-publicized, the whole class pays an increased risk premium. One would then expect that well-run cities would pay higher rates based on defaults elsewhere. That would make good debtors in a bad class of debtors to be more attractive, as in underpriced, IF the investor could sort out one from the other.

    4. Bruno Behrend Says:

      Municipal Bonds, and the rent-seeking and greed that surround the industry, would make an excellent book. “Liar’s Poker” comes to mind.

      The last decade or so has seen the rise of an entire class of “rent-seeking entrepreneur” that has made billions off of churning public debt.

      It starts with “tax preferred” status (mortgages, no capital gain on the sale of a home you’ve lived in), and goes down hill from there.

      If the Feds passed a law creating a moratorium on any and all municipal debt (save perhaps for rollovers that lowered interest rates) we would give the citizens an extended breather from the local government Czars that have mortgaged your kids’ future.

    5. Simon Kenton Says:

      Not discussed (at least that I have seen) are the bonds where, as a part of an enterprise zone or a monument to advanced social ideals, a municipality has provided its name and tax exempt status to ostentaciously worthy private or non-profit entities. Nursing homes, for instance, particularly ones with a religious body providing the management. These will provide a collapse trigger if the mismanagement by the cities themselves doesn’t.