Have I seen This movie before? Two years ago, analysts were predicting default rates as high as 17% for Junk bonds in the wake of the financial meltdown, taking yields on individual issues up to 25%. Liquidity in the market vaporized, and huge volumes of unsold paper overhung the market. To me, this was an engraved invitation to come in and buy the junk bond ETF (JNK) at $18. Since then, the despised ETF has risen to $40, and with the hefty interest income, the total return has been over 160%. What was the actually realized default rate? It came in at less than 0.50%.
Fast forward three years to today (has it been that long?). Bank research analyst Meredith Whitney is predicting that the dire straits of state and local finances will trigger a collapse of the municipal bond market that will resemble the Sack of Rome. She believes that total defaults could reach $100 billion. Since September, the main muni bond ETF (MUB) has plunged from $106 to $97.
I don’t buy it for a second. States are looking at debt to GDP ratios of 4% compared to nearly 100% for the federal government, which still maintains its triple “A” rating. They are miles away from the 130% of GDP that triggered defaults and emerging refinancings by Greece, Portugal, and Ireland.
The default risk of muni paper is being vastly exaggerated. I have looked into several California issues and found them at the absolute top of the seniority scale in the state’s obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders.
How many municipal defaults have we actually seen in the last 20 years? There have only been two that I know of. The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. And Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn’t understand sold by, guess who, Goldman Sachs. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression.
My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting. The market is currently pricing in the triple digit number.
Let me preface my call here that I don’t know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the “C” average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with major offshore institutions and foreign governments for whom the tax advantages of owning munis have no value.
However, I do know how to use a calculator. Decent quality muni bonds now carry 8% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 16%, almost as high as the peak we saw in the junk market in 2008. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.
Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.
There is one additional instructive thing that is going on in the muni market. The mayhem that we are seeing is but a preview to the real violence that we will see when the US Treasury bond market starts to collapse, possible in a few months. That I can trade, through the leverage short ETF (TBT). This is the real lesson of what is going on in muni land.
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By. Mad Hedge Fund Trader
