August 31, 2012

4 Strikes Against Municipal Bonds

It’s easy to contrast the muni-bond market of 2008 with today’s landscape – but there are significant differences

From financial myths to economic decoupling and outright lies that housing prices are incapable of declining more than 20%, many investors have heard their fair share of nonsense.

This time around, there’s plenty more propaganda floating around, particularly in the $3.7 trillion municipal bond market. While muni bonds have been lauded for their tax-free income and relative safety, the investing landscape has dramatically worsened.

Let’s analyze four key reasons.  

1.  The lack of transparency

In early August, the Securities and Exchange Commission criticized the municipal bond industry for its illiquidity and lack of transparent pricing data. A scathing report from the State Budget Crisis Task force echoed similar concerns.

“Opaque and untimely reporting, coupled with nonexistent multiyear planning, severely hampers efforts to address these problems in a serious manner,” the report said. What’s the problem?   

Unlike stocks, mutual funds, and ETFs, municipal bonds aren’t heavily regulated, but rather, governed by a self-regulatory organization (SRO) called the Municipal Securities Rulemaking Board or MSRB. Despite all of the benefits that SROs like the MSRB may have, strictly enforced rules and rigorous disclosures aren’t among them. 

2.  Bond insurance has dried up

The purpose of bond insurance is to guarantee the payment of principal and interest if the bond issuer defaults. Insured bond ratings are based upon the credit quality of the insurer, not the bond issuer. And therein lays the problem: What if the creditworthiness of the bond insurer implodes?

During the go-go years, municipal bond insurers simultaneously issued insurance on collateralized debt and other securitized rubbish. Unfortunately, that exposure, in addition to nuclear bombing the financial system, threatened the claims-paying ability of insurers and resulted in ratings downgrades. In 2007, there were seven muni bond insurers rated triple-A. Today, none of those same insurers are rated triple-A.

It’s easy to contrast the muni bond market of 2008 with today’s landscape. Back then, more than half of the $2.5 trillion in municipal bonds were insured. Today, just around 10%of muni bonds are insured, and Assured Guaranty (AGO) is the only significant muni bond insurer.

 3.  Defaults are materially higher than reported

There still exists a fanatical constituency that adamantly believes widespread municipal bond defaults aren’t possible. They are quick on the draw to cite data from major rating agencies, which show municipal bond default rates have followed a historically low pattern. But recent findings from the Federal Reserve Bank of New York debunk this claim.

The study found that rating agencies are only counting defaults for the municipal bonds they rate, and as a result, they’re providing a false picture of actual default rates in the muni bond market.

Instead of agreeing with Moody’s 71 listed defaults from 1970-2011, the Fed’s database shows 2,521 defaults during this same period.

Similarly, the Fed’s data shows 2,366 defaults from 1986-2011 versus S&P’s 47 defaults during this same period. In total, the Fed discovered 2,527 muni-bond defaults from the period beginning in the late 1950s through 2011.

Put another way, credit rating agencies are understating historical default rates in the municipal bond market because they exclude unrated bonds. As a result, bond investors have been given a false sense of security.

 















4.  Savvy investors are bailing

When Berkshire Hathaway Assurance was formed in 2008, it was perceived as Warren Buffett’s bullish bet on a recovery in the municipal bond market. But those were different times. Decent sized cities like Harrisburg, Pa.; Stockton, Calif.; and San Bernardino, Calif., hadn’t yet gone bankrupt. Is Buffett still bullish?

Even if the public doesn’t get it, Buffett understands the danger of faltering credit quality and only a stubborn fool would ignore his cues. His holding company, Berkshire Hathaway (BRK-A), recently ended credit default swaps insuring $8.25 billion in muni bond debt. Put another way, his bullish bet is over.

Diversifying credit risk via broad muni-bond ETFs like the PowerShares Insured National Municipal Bond Portfolio (PZA) or the iShares S&P National AMT-Free Municipal Bond ETF (MUB) is a good idea, but a more aggressive approach toward protecting capital may be required.  

Through the first half of 2012, investors sunk an amazing $31.56 billion in muni bond funds. Not only does the existing pace easily beat last year’s, but it’s 40% more than the record inflows experienced during the first half of both 2009 and 2010!

Complacency is off the charts.

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The ETF Profit Strategy Newsletter analyzes the $3.7 trillion municipal bond market, identifying key inflection points that will radically alter this mega market. Warning signs are everywhere, but so are opportunities for astute advisors.

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