I have been opposed to municipal fund investing for a couple of years now ever since the market crash of 2008. Initially, my reasons were only fundamental in nature but in November 2010, the technical aspects turned bearish as well.
Let’s first look at The WSJ’s updated report in “New Hit To Strapped States:”
With the market for municipal bonds tumbling, cities, hospitals, schools and other public borrowers are scrambling to refinance tens of billions of dollars of debt this year, another sign that the once-safe market is under duress.
The muni bond market was hit with the latest wave of bad news Thursday, prompting a selloff that sent the market to its lowest level since the financial crisis. A New Jersey agency was forced to cut the size of a bond issue by about 40% because of mediocre demand, and pay a higher rate than expected. And mutual fund giant Vanguard Group shelved plans for three new muni bond funds, citing market turmoil.
“We believe that this delay is prudent given the high level of volatility in the municipal bond market,” said Rebecca Katz, spokeswoman for the nation’s biggest fund company.
The market has fallen every day this week, and investors have been net sellers of their holdings in municipal-bond mutual funds for nine straight weeks, according to fund tracker Lipper FMI.
Yields on 30-year triple-A rated general obligation bonds shot higher to 5.01% on Thursday, reflecting a spike in perceived risk, according to Thomson Reuters Municipal Market Data. The last time those bonds yielded 5% was Jan. 30, 2009, during the financial crisis.
Amid the selloff, public borrowers such as states and utilities face a wave of refinancing stemming from deals cut mostly during the crisis. The deals involved letters of credit from banks that were designed to keep financing costs down for government entities in need of cash.
Though the financing deals can be meant to last decades, the letters of credit underpinning them are expiring sooner. That could force the borrowers in many cases to pay higher interest rates or seek guarantees at higher costs. For the weakest borrowers, new guarantees may not be available and refinancing too costly. There are about $109 billion worth of letters of credit and similar backstops expiring this year, according to Bank of America Merrill Lynch. Some $53 billion in letters of credit alone is expiring this year, according to Thomson Reuters.
“Municipalities may be hard-pressed to come up with this money or refinance this debt,” said Eric Friedland, a municipal analyst at Fitch Ratings. The ratings firm is scouring to identify risks among weaker municipalities that are seeking to renew these deals, and says it could downgrade some.
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The short-term squeeze is unusual in the $2.9 trillion municipal bond market. Most debt is paid back over decades. And state and local governments generally don’t need to borrow money to fund their daily operations. The long-term nature of the market is a key reason why most experts don’t see the problems with state and local government debt spiraling into another financial crisis. Analysts say that many large states and cities with good credit ratings have been able to roll over deals well ahead of their expiration.
But there are parts of the market where short-term cash crunches could emerge, leading municipalities to potentially default on their debts. The risks could spill over to banks that backed bonds with the letters of credit.
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The biggest concerns, analysts say, are smaller muni borrowers such as hospitals and schools that have subpar credit.
Municipalities borrowed $122 billion of variable-rate demand debt in 2008, roughly twice the amount of these types of loans borrowed the year before, according to Thomson Reuters.
Rollover crunches were a major part of the financial crisis, as banks that had relied on short-term debt couldn’t borrow and became insolvent. More recently, rollover issues contributed to Greece’s financial crisis.
Banks are reluctant to renew the letters of credit in part because of impending rules that restrict the amount of risk they can take.
Besides banks, one provider of muni letters of credit is the giant California pension fund, the California Public Employees’ Retirement System, which has back-stopped $2.5 billion of adjustable-rate bonds.
Calpers’ chief investment officer, Joe Dear, said in an interview that the pension fund partly uses the letters to make it easier for local California entities to borrow money, but it has no plans to ramp up its involvement in such deals.
“We, like a lot of people, are watching the muni market, and it is not getting any healthier,” said Mr. Dear.
While there is a lot of analysis being done and forecasts abound as to the magnitude of the muni problem, there is an easy way to see where the muni market is at. I am, of course, talking about simply look at the trend.
The 2-year chart above shows PZA, which tracks the Long-Term Core Plus Municipal Securities Index, which normally invests 80% of its assets in insured muni securities.
As you can see, the trend line was broken to the upside in April of 2009, generating a buy, and did not drop below it until November 2010. That break below coincided with PZA coming off its high by 5%, which triggered our trailing sell stop. While we only had limited holdings, we liquidated them at that time.
Since then, it’s been straight down into bear market territory. If you like investing in munis, I suggest you wait until the price breaks the trend line to the upside again until establishing positions.
Don’t try to be a hero by attempting to bottom fish now; it’s very easy to do something very stupid as no one can tell when we really have hit bottom.
With the markets being closed on Monday, I will return on Wednesday morning with Tuesday’s market report.