Saturday, March 01, 2008

Municpal Bond Market

The municipal bond market, usually one of the safest markets around, got creamed yesterday. The cause was forced selling by muni arbitrage funds who attempt to exploit the difference between the yield on munis and other types of debt (usually Treasuries). What these funds typically do is short Treasuries and buy munis when the spread gets too wide. This gives them an opportunity to benefit when the spread narrows without subjecting them to interest rate risk.

So the moves yesterday in the muni market and the Treasury market were a result of the spread widening to unprecedented levels. As Treasury yields fell, muni yields rose; so much that now, in some cases, tax free muni bonds yield more than comparable Treasuries. As Treasury yields fell, the arbitrage funds were hit with margin calls. This forced them to sell the munis and buy Treasuries (to cover their short positions) which futher exacerbated the situation.

I warned about this not too long ago:

If that market continues to fail, those leveraged funds may be forced to sell bonds into the same market where the issuers are trying to refinance. And that will mean higher rates than otherwise would have prevailed. Taxpayers lose again.

In that post though I was referring to closed end leveraged muni funds. These funds work a little differently; they issue auction rate debt at short term rates and use the proceeds to buy long term munis at higher rates. Borrow short and lend long. Guess what; these leveraged funds have not been forced to liquidate yet. That may still happen if the auction rate market continues to fail and that will mean even greater bargains in the long term muni market. So I'm keeping my powder dry for another down leg. I may start to buy some munis soon, but I don't think there is much of a rush.

I don't know if any muni bond issues were scheduled for next week, but if they were, my guess is they will be canceled due to the higher rates. Just as I predicted, taxpayers will pay for this mess.

This is what Nassim Nicholas Taleb warned about in his book, The Black Swan: The Impact of the Highly Improbable . The fact that something has never happened before, such as tax free bond yields exceeding those of taxable bonds, does not mean that it cannot happen. And when it does, the losses can be huge. Just ask anyone who invested in Long Term Capital Management, another fund based on the idea that black swans don't exist.

Here's the good news. For those of us who always keep some cash on hand (our accounts are about 8% cash right now), this represents a great long term opportunity. We have Treasuries in our portfolios which have benefitted from this and now we have the opportunity to sell those at a profit and buy long term munis with the proceeds (as well as using some of our cash). As I said earlier, I don't think there is a huge rush as some other leveraged funds may be selling soon, but even if we buy now, I suspect that we will profit over the longer term.

Here's the bad news. We don't know what interest rates will do. With inflation running hotter than anyone expected (except for maybe us and a few commodity traders) interest rates could rise. There is the possibility that we buy munis at these rates and if rates rise, the price could fall futher. We can minimize the risk of that by doing what these arbitrage funds were doing; short Treasuries and buy munis, but then we would be taking the same sort of risk that they did. Of course, we would be entering the trade at a much better price than they did, but what if a flock of black swans shows up at my door?

I think the best option at this point is to be patient. If the auction rate market is any indication, there is no rush. That market started blowing up a few weeks ago and still hasn't returned to normal and it may never. The market for regular munis will return to normal at some point though, so I will be looking to be a buyer at some point.

By the way, the auction rate market is still failing. I've seen a lot of comments on the web from investors who own these securities and the mood is ugly. Most of these investors had no clue what they were buying. It seems in many cases their brokers did not even tell them what they were doing with their money. These investors are mad at their brokers and threatening to sue. A couple of points need to be made here. First of all, when you open a brokerage account at most of the major firms, you agree to settle disputes via arbitration so a lawsuit isn't going to happen. Second, if you give your money to a broker and don't demand full disclosure about what they are selling, you have some responsibility for the losses as well. Brokers get paid to sell you things and they will sell anything they can get you to buy. Caveat Emptor - let the buyer beware. It's your money and you have to take some responsibility for how it gets invested.

If you don't want to take that responsibility, you need to hire a Registered Investment Advisor. Unlike brokers, RIAs are considered fiduciaries - they are held to a different standard and must look out for your best interests. In short, an investment advisor works for you. A broker works for his firm which is in the business of selling investment products. Investors should never forget that.

1 comment:

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