Sunday, November 21, 2010

Muni bond market

Something is wrong in the municipal bond market. Interesting opinions on this topic:

Warren Buffet: Muni Bond Market May Be Next Phase of Financial Crisis

How to Play the New Muni Market:

Municipal bonds are backed by local or state governments or other public entities. Investors like them because their interest payments are generally exempt from federal income tax, though states often levy taxes on out-of-state bonds.

A freakish confluence of events sparked the selloff. Treasury yields rose, which led to losses on all types of bonds as investors sold older bonds to make room for newer ones. A massive amount of muni-bond supply hit the market—about $34 billion through Nov. 19, the average issuance for an entire month in 2010. And the Republicans' retaking of the House of Representatives on Nov. 2 made it more likely that the Bush-era tax rates will be extended for all taxpayers, reducing the urgency for upper-income earners to hold tax-free munis, and threw into question the future of the Build America Bonds program, in which the federal government subsidizes municipalities that issue taxable bonds.

The problems started when bond insurers, with massive exposures to subprime mortgage debt, fell on hard times. Now they are exiting the muni market in droves. Whereas about half of all newly issued bonds in 2006 carried insurance, that number has fallen to about 7% in 2010.

The financial crisis also drained the muni market of liquidity. Bear Stearns and Lehman Brothers were two major muni-bond dealers before they blew up. Other banks and brokers have been less willing to hold large amounts of muni bonds on their books, while some hedge funds that used "arbitrage" strategies in the municipal-bond market pulled back or disappeared.

The market's fragmentation makes it difficult for investors to gauge whether munis are cheap or expensive.

Back when more of the muni market was insured, the direction of interest rates was the primary driver of yields. Treasurys and municipal bonds typically moved in the same direction, with a fairly predictable ratio between their yields.

The historical average was around 82% for 10-year bonds, because that was the ratio that produced a yield roughly equal to a Treasury once taxes were factored in (the "taxable equivalent yield"). When the ratio moved higher or lower than that, it signaled a buying or selling opportunity to some investors.

Now the direction of interest rates is just one of many drivers of muni yields, and the relationship between Treasurys and munis has weakened, say traders and analysts. The correlation between the two since 2008 is just 1%, versus an historical average of 91%. (A correlation of 100% means two assets move in lock step; a correlation of -100% means they move in complete opposition.) So while the taxable-equivalent yield ratio is now 103%, it doesn't mean munis are cheap.

The recent trading in ETFs and closed-end funds shows how tricky it can be for investors to value a muni portfolio. Muni-bond ETFs, which trade on exchanges like stocks, are generally more liquid than the bonds they hold, so there can be big differences between the two during periods of volatility.

For example, the iShares ETF and the SPDR Nuveen Barclays Capital Municipal Bond ETF on Tuesday traded about 2% below the value of their underlying holdings, according to investment-research firm Morningstar Inc. Before November, both ETFs had generally been trading within 0.5% of their net asset values this year.

Investors should focus on national muni funds rather than their single-state competitors, analysts say. And they shouldn't be too tempted by the higher yields now available—there still is more pain to come, say advisers. "There will be a general decline in credit quality," says Warren Pierson, comanager of the Baird Intermediate Municipal Bond Fund. "I think you'll see more downgrades than upgrades," which would hurt muni-bond prices.

Instead, investors should focus on high-quality short- and intermediate-term funds. Bond prices fall as interest rates rise, and longer-term holdings are more sensitive to these shifts. That is especially important given the uncertainty about the Build America Bond program. If it is allowed to expire at the end of the year, there could be a fresh flood of long-term municipal issues, which could cause long-term muni prices to drop.