In the United States, state and local governments across the country are experiencing similar debt and budget deficits that the individuals, organizations, and federal government are facing.
In the grand scheme of things, I think we will see a significant amount of risk being transferred to the federal government; in other words, I expect the federal government to “bailout” individuals, organizations, and state and local governments. I view this as one of the major economic shifts going on that the market has not fully priced in yet.
So what’s the trade?
If we expect risk to be transferred from municipal bonds to Treasury bonds, we can look to buy MUB — an ETF corresponding to the S&P National Municipal Bond Index — while also buying TBT, an ETF inversely correlated to 20+ year Treasury bonds.
Timing is always the issue, of course. One indicator we may find to lead the way would be CXA, an ETF tracking municipal bonds in California. As one of the largest economies within the United States, it can be seen as an indication of where the country is headed. Here are some key insights:
The purple and yellow candles are CXA; the red and green are MUB, while TLT is blue and gray. If a sizable bailout does occur and the market has not priced this in, it would be a transfer of risk from the states to the federal government, and thus from CXA and MUB to TLT. We would then expect to see the prices converge. If California is a leading indicator, we may expect to see CXA pave the way.
Other Considerations
There is a question of the legality of the federal government assuming responsibility for the state governments. Thus far the Federal Reserve’s bailouts have not been questioned, and thus a precedence of sorts has been set. States have resisted Federal mandates before, so the issue of states rights vs. federal rights may arise again, and may impact CXA, MUB, and TBT as well as other ETFs and investment opportunities.
We have already discussed the forced selling of bonds by hedge funds and pension funds in 2008. Many funds were forced to sell their bonds just because they needed the money for margin calls from other collapsing investments.
Another reason for the decimation of municipal bonds during 2008 was that all of the ‘municipal bond insurers’ went caput. Mutual Bonds Insurers were found do be wearing no clothes. They didn’t have enough assets to cover the companies they were insuring. When that happened, hedge funds got very nervous and sold their bonds.
Allow me to elaborate.
In the old days (a few months ago), municipal bonds used to be ‘insured’ against default. Having insurance made municipal bond holders feel good. Why? Well with bond insurance, shit could happen and if it did and the bond defaulted or the city blew up it didn’t matter cause there was a municipal bond insurance company who issued ”insurance” to cover your bond.
Just to clarify–the role of the municipal bond insurer was to pay the bondholders IF the bond defaulted. The analogy is that if your house burns down and you have insurance, the insurance company pays you. With insurance, you feel pretty dern good.
Well, bond insurance was a nice ponzi scheme idea in theory, until the bond insurers discovered that they really had no money inadequate balance sheets. It was also a nice cash cow for Insurers because municipal bonds rarely default.
In 2008 , bond insurers got busted on the playground . Report cards were issued for these insurance companies and it was not pretty. Nearly all of the bond insurers were downgraded to non-investment grade , or worse yet, JUNK BOND status. Wall Street freaked out. On top of the deleveraging that was already taking place, they now had no insurance for protection. Whoops.
So, when the financial world discovered that the companies who sold insurance to protect the bonds were turning into JUNK, everybody went into even more shock and sold. So, this was yet another reason why municipal bonds were decimated in 2008.
And so it came to be that at the beginning of 2009, there was not really a reliable company to insure municipal bonds. With questionalble or no insurance coverage, everybody became really afraid to buy municipal bonds.
The really big $64 question remains: With the municipal bond INSURANCE market now in ashes, do we really need insurance anyways? Just yesterday, one of the old insurance companies, MBIA, rose from the ashes in an attempt to go back to insuring municipal bonds. However, they _still_ have a terrible credit rating . Can we trust them? But does it really matter?
Apologies for the lack of update - this semester has been rough in terms of work. I’m going to try and update more often, but not always with completely original content - that’s nigh impossible with my classes/wrestling/band. Rather, from time to time, I will upload articles and documents that I like and think you should read. Generally, I’ll try to provide a good summary and/or critique that expands upon the content, rather than regurgitating what I read.
This week’s article is especially important because, simply put, green is the future. Green initiatives and environmentally-friendly engineering are no longer the pipe-dreams of hippie tree-huggers - they are now cost effective and government subsidized. It has simply makes no sense to stick to the old energy paradigm. The skyrocketing cost of fossil fuels in 2008 alone contributed to $4.50+ gasoline, $2.75 heating oil and 20%+ increases in electricity bills. Granted, there are a variety of other factors that contribute to this kind of price fluctuation, but the source of the problem still lies in a reliance on inefficient energy resources. Sustainable is the new magic word, and for good reason.
So, what’s a great way to invest in a cleaner, safer, efficient, independent America? As Ramsay Mameesh puts it,
Green Municipal Bonds offer the opportunity to rescue the economy and the environment. Local governments are needlessly watching their economies disintegrate, waiting and begging for handouts from Washington D.C., while all along the power to save their economies and help the environment lies in their hands - Green Municipal Bonds.
There are three main agencies which rate bonds. These ratings apply to corporate and municipal bonds. A downgrade or an upgrade from one of these agencies usually results in a stampede for the door (entrance or exit). Unfortunately, most of the doors right now are only exit doors.
The most damaging downgrade is when a bond gets downgraded from ‘investment grade’ to
‘non investment grade’. This is the area below BBB. Besides just the stigma attached to becoming a non investment grade bond, this is considered a material and significant event for insurance companies, pension plans and mutual funds whose charter specifies that they can only invest in ‘investment grade’ bonds. For these companies, when a bond gets rated lower into the ‘non-investment grade’ abyss, they must sell the bond. So, you will see extreme selling of bonds when this type of downgrade occurs.
You can see from the chart that each agency has it’s own proprietary Report Card using letters. One would think that a similar grading scale across the board (all agencies) would make this easier for the average investor. Whatever!–this chart sure comes in handy.
Even if you don’t plan on buying bonds, bond ratings are often predictors of what direction the equity market (stocks) will take. Rating agencies evaluate the health of the city or state(municipal bonds), or company (corporate bonds). For the most part, equity investors of company stocks rely on quarterly reports to evaluate a company’s balance sheet. Bond ratings come out at various times inbetween quarterly reports, giving investors a preview of the health of a company.
As you can see, a number of small changes have been made to the site, but the most significant have been to the Videos page. There’s a new player up and it generally looks a bit more organized/neat.
And now, for the fourth and final segment of my series entitled, “Munis: So Hot Right Now.” Although the subject matter seems as though it should have been posted before my last segment, I felt it necessary to put this part last to emphasize the strength and security of municipal bonds. I am of the opinion that munis really are a shining beacon of hope in an otherwise dismal economic situation. I hope that, by the end of this post (and the series as a whole), you will understand and take action as well.
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IV. Why munis as opposed to other bonds/equities?
Besides the awesome feeling you’ll get knowing that you’ve invested directly in community (state and national) resources, what reason is there to put your money into munis rather than the countless other bonds and equities at low prices? Let’s not forget that low prices generally mean things are going bad - hence, the term “junk” bonds. Doesn’t the same danger of bankruptcy apply to munis too?
Let me answer that question with another question. When is the last time you heard of a municipality defaulting? Have you ever really heard of a state, or a city, going bankrupt? Sure, it’s happened before, but the rate of default for munis is extremely low. If public stocks have about a 3% chance of defaulting (I’m guessing here), then corporate bonds have a rate of about 1%. Municipal bonds are approximately 1/100 as likely to default as their corporate cousins. Think about how low that risk is in contrast to your potential gains (see above example)!
Why is the rate of default so low for munis as opposed to equities or other types of bonds? It all comes down to the nature of state/city finances versus those of corporations.
Corporations are powerful money magicians. They have tricks (stock options, derivatives, multiple books etc.) to pull money out of thin air and/or distract the investor from what’s really going on with company finances. It’s all very dangerous and unwieldy, and it’s the fundamental reason behind the credit crunch we’re experiencing now.
Municipalities (state/city/national holdings), on the other hand, care only about one thing - balancing the budget. There are no funky backroom dealings. Everything is out there on the table. It’s like your mom told you - honesty is the best policy (especially in finance).
Furthermore, we have Barack Obama coming in as our next president. Although his socialized leanings on economic policy reform are questionable, they suggest that he’s highly unlikely to let a state or city experience financial distress for very long. I mean, come on - bailing out a township is going to receive more positive feedback than the recent corporate bailouts, at least from the American public.
Obama is good for municipal bonds
From examples and from recent historical context, we have learned that munis are smart, cheap, and efficient. The time to take advantage is now, though - don’t wait. It may be a while, or it may be next month when President Obama lays down another TARP for municipalities - in which case, these bonds will go up in price and yields will be realized even quicker. I wish you the best of luck in the upcoming fiscal year - may the muni be with you.
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That’s it for my series. I hope you enjoyed it - and if you have any questions, please use the contact form to reach me.
Linked below is a great column by Mark Whistler. The basic idea is similar to what I’ve been outlining in “Munis: So Hot Right Now”: despite the frightening nature of the subprime crisis, munis are generally safe from default and are in fact benefitting from the overall situation.
Whistler also makes an interesting case for ETFs, which are basically mutual funds for municipal bonds. This “hybrid” entity takes munis (safe, low cost, currently producing high yields) and packages them into a powerful liquid investment (ETFs trade intraday). These characteristics provide the investor with the flexibility to engage in anything from agressive day-trading to “buy and hold” using the vast array of specialized ETFs available.
Today’s installment is focused on practical application of the knowledge we’ve gone over thus far. You can reference this post when you’re looking at the three parameters of other munis, just in case you forget what everything means in context.
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III. What do I do now?
Enter you, the lay investor. You are a true rogue agent, a splinter cell - you owe allegiance to none but yourself. No silly contracts bind you. You look to your old friend, the ACY formula, for guidance: ACY = [(Coupon ÷ Price) x Face Value] + [(Face Value - Price) ÷ YTM]
Like any true friend would tell you, he says:
1) Buy at a low price,
2) Go for a higher coupon (if possible), and
3) Look for a short maturation period (small YTM)
To understand this advice, let’s flesh out an example. Thanks to Kevin Olsen’s work out of the site municipalbonds.com, anyone can see the highest and lowest yield trades for almost every day of the past 10 or so years. We will use the data from an exchange from the beginning of this year - the muni for the Sheppard Pratt hospital in Baltimore, MD. It can be found here (URL: http://municipalbonds.com/yields/yieldbuyers/20090102.html)
Look three rows down, and you’ll see it. Some very smart and quick individual bought this muni on the 2nd of January for 93 cents on the dollar (the actual value is 90, which is what we use for the calculation). The annual coupon is 5% (as usual), and the YTM is an astoundingly short 6 months. And the kicker? From all of that, this lucky person is getting a 21% yield on his investment in exactly half a year. Let’s plug in the values to see exactly how that happens. [(Coupon ÷ Price) x Face Value] + [(Face Value - Price) ÷ YTM] = ACY
[( 0.05 / 90 ) x 100 ] + [( 100 - 90 ) / 0.5] = 21
Now, the calculation shown here is approximate - you won’t get the exact values shown on the site (this calculation actually gives you a 20.55% return yield instead of 20.93%), but you get the general idea. Look for a low price and a short maturation period, and you’re in the green. A high coupon is nice, but if it’s too high (something ridiculous like 80%) then you know something’s wrong. Use your common sense, and you’ll be fine.
Here’s part II, as promised. This is more of the history behind the market crisis, and why it’s affecting the individual investor positively with concern to munis.
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II. The Bear Raiseth His Head…
The year 2008 saw de-leveraging on a scale that hasn’t been witnessed since the Great Depression. Everyone, from Ma and Pa investors to mutual funds and hedge funds, had to liquidate at an unprecedented rate. Individual investors wanted to keep their money safe, so what did they do? They sold whatever they had - bonds, equities, etc. - as fast as possible in order to escape the calamity of the Bear market. Investors who had their money tied up in larger operations (mutual funds, hedge funds, investment banks, etc.) called up their respective investment entities to demand it back. Faced with these redemption requests, all of these companies were forced to scrounge money from whatever source possible. Money doesn’t grow on trees, so almost all of them ended up having to sell massive volumes of bonds and equities just to meet investor demands (as well as conforming to regulation on part of bond ratings, more on this later). And what, my friends, happens in huge sell-offs? Prices dive.
Munis, which almost never stray from the 100 mark, have gone down to 90, 85, 80… even 70 cents on the dollar. Let’s look back at the formula: ACY = [(Coupon ÷ Price) x Face Value] + [(Face Value - Price) ÷ YTM]
See that inverse relationship between yield and current price? We’ll flesh it out later - try not to wet your pants (yet), because things gets even better for you.
Let’s first backtrack a little bit. Take the hypothetical example of a larger investment body that could have survived the stock/bond market massacre through sheer attrition. What if said company wanted to keep some of those bonds? Well, that depends on what the bond rating agencies say.
There are about two or three major bond rating agencies out there, and frankly, they’re all pretty sketchy. I’m not sure what criteria they use to make these market-altering value judgments, but they apparently have the authority to pass out “report cards” to various bonds. The “grades” go something like this: A, AA, B, BB, and so on. Any bond that has a rating lower than BB is considered a “junk” bond.
By charter, large investment entities (mutual funds, hedge funds, investment banks, venture capital bodies, etc.) cannot hold junk bonds. This is the second huge reason why they had to sell a lot of bonds during the economic crisis, and the biggest reason why you should be getting into munis now.
At this moment, everything looks dismal, and ratings are way down - for all bonds, not just munis. Everything looks like “junk.” Plus, it looks bad for any market when big investing firms are showing absolutely no signs of activity. What you now know is that they probably WANT to, but their hands are tied! This is an unbelievable deal in an otherwise compromised economy.
