Jan 25, 2011
Is Now the Time for a Contrarian Bet on Muni Debt?
By Andrew Mickey, Q1 Publishing
Standard & Poor’s warned a lot more municipal debt downgrades are coming.
Does that mean the bottom is in for muni bonds?
Normally, it would be. S&P and the other members of the debt rating oligopoly have a long history of downgrading debt when a borrower’s problems are obvious.
For example, S&P cut Ireland’s debt rating from “AA-” to “A” last November the same day riots broke out in the streets.
It cut Enron to its lowest “investment grade” rating after shares plummeted from $80 to $7 and about a month before the company filed for bankruptcy.
In 2008, S&P downgraded 37 municipalities’ debt. Last year S&P was playing catch up again when it downgraded 343 municipalities’ ratings.
There are countless other examples, but you get the point. The rating agencies are extremely cautious when adjusting its debt ratings.
That’s why when the rating agencies start to officially acknowledge reality, you know the problem is about to come to a head. Right now, it’s muni bonds.
And in a market where the major indices have reached exceptionally high levels, assets like commodities and emerging markets which have the best fundamentals in correction mode, and “safe” long-term bonds pose more risks than they have in decades, contrarian investors should be getting the itch to make a contrarian bet on beaten-up muni debt.
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The Race for the Exits
Muni bonds have come under significant pressure in the past few months.
The morning after the U.S. elections the muni bond market realized a federal bailout of state and local governments was virtually off the table and began dumping muni bonds.
Last week investors pulled more than $4 billion out of municipal bond funds. The week before investors pulled out $1.5 billion. That’s a record sell-off for a two-week period.
The accelerating sell-off capped a 10 straight weeks of outflows from muni bond funds of $20.6 billion.
In the last three months the iShares National Muni Bond ETF (NYSE:MUB) has fallen to levels not seen since the credit crunch of 2008. The fall has wiped away more than two years of gains for muni bonds in a matter of weeks.
Individual investors dumping assets indiscriminately is usually a good sign the bottom is in or, at least, near.
History has proven individual investors buy and sell at the worst possible times.
In a past Prosperity Dispatch we observed:
As a whole, mutual fund investors put money in and pull it back out at the worst possible time. The tech bubble is the perfect example. In 1999 and 2000, money flowed into technology-focused mutual funds. At the peak of the tech bubble in March of 2000, about 80% of all money in mutual funds was in the technology funds. All of that new money pushed the NASDAQ to a peak of more than 5,000.
When the downturn came, which it always does, the leading technology mutual funds lost 60% to 80% of their value as the NASDAQ plummeted back to 1,000. And most mutual fund investors weren’t selling out along the way.
Mutual fund investors waited and waited for a rebound to come. In typical fashion, most were unwilling to give up hope and take a loss at first. However, after the NASDAQ slid lower and lower each day over the next two years, they began to sell out.
As usual, they were selling at the worst possible time. In 2002 and 2003 when the major market indices were bottoming, mutual fund outflows were at their peaks.
Now they’re at it again with muni bonds.
That’s surely a bullish signal for muni bonds. But it’s not all we have to rely on.
Another indicator signals the bottom in muni bonds probably isn’t in just yet.
This Indicator Never Lies
One of our favorite indicators – more than surveys and other subjective data – is the Closed End Fund (CEF) Indicator.
The CEF Indicator shows what investors are actually willing to pay for certain assets. And since CEFs trade at a discount or premium to their underlying net asset value (NAV), we can see directly how much investors are willing to pay for certain financial assets.
If a CEF is trading at a 10% premium, investors are very bullish. They’re paying $1.10 for $1 worth of assets.
If a CEF is trading at a 10% discount, we know investors are bearish. They’re only willing to pay 90 cents for $1 worth of assets.
A quick look at the premium/discounts on the largest muni bond funds relative to their historical average paints a much different than the media:
The indicator shows the sell-off in muni bonds still has not reached an extreme low yet.
When asset classes hit extreme lows, CEFs trade at extreme lows relative to their NAVs. Historically, that’s a strong indicator of rock bottom.
Right now the leading muni bond CEFs are still trading at premiums higher than their five-year averages.
Here’s why we haven’t reached truly rock bottom yet.
Pulling Budgetary Rabbits Out of Hats
Much has been made about state and municipal governments’ budget situations. They’re in bad shape and getting worse.
Still, despite massive annual deficits that need to be closed, they manage to get by each year.
There are a number of reasons for this. The big one is that the debt levels of state and municipal governments are not at unsustainable levels just yet.
The Center on Budget and Policy Priorities, a left-leaning
think tank, recently noted in a recent report how bad state and local government debt have really gotten:
The chart shows the total debt is still below historical peaks for the time being.
Of course, the chart excludes unfunded pension obligations and other off balance sheet obligations, but it is a good snapshot of the real debt levels.
The Wait Will Be Over
In time, the actual debt levels will continue to grow as pension funds fail to meet their excessive investment returns expectations , the lower-than-expected tax revenues generated by tax hikes become apparent(reference: Illinois future), and increasing demands on state and local governments due to new healthcare mandates, education cost increases, and other government-funded spending push them over the brink.
For now, municipal governments aren’t “tapped out” when it comes to borrowing more. They have borrowed more in the past and still have a ways to go before they surpass the levels of the late 80s.
And there are still rabbits that politicians can pull out of their budgetary hats. Whether it’s skipping payments to pension funds, borrowing money from local governments, delaying payments to contractors by months or years, or selling building to lease them back, there are still some options for most of them.
When those options start to be exhausted, investors start to demand more than 3% to 5% per year in interest muni debt is paying, you can buy muni debt closed-end funds at record discounts, and the rewards significantly outweigh the risks, it’ll be time to start buying up muni debt.
That time may come sooner than later. Muni bonds are assets to definitely put on watch list. The window of opportunity will open eventually. But for now, it’s likely a bit too early.
Good investing,
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
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