Monday, March 03, 2008

Not Time to Buy Munis Yet

The WSJ has an article today about the near universal bullishness in the municipal bond market. I suspect this means the bottom is not in yet. When everyone is bullish, I get nervous:

There aren't many places to hide in today's tempestuous markets. Stocks took a beating late last week; Treasury bonds offer skimpy yields, and corporate debt looks vulnerable to recession.

Municipal bonds have suffered losses, too, but there veteran investors are strongly bullish, saying they have little doubt they see the greatest buying opportunity of their careers.

There are a number of reasons to wait. First, is that the failure of the auction rate market means that many of the issuers in that market are trying to refinance by selling long term bonds. That will increase the supply of bonds and that is rarely good for prices. The second is that the same auction rate market is still failing and the leveraged closed end funds that issue preferred stock there will eventually be forced sellers in the muni market.

What I am hearing is that the preferreds issued by the closed end funds are not resetting at significantly higher rates so the auctions are all failing. These preferreds are mostly perpetual meaning they don't have a maturity date. If the auction rate market does not return to normal what will these closed end funds do? I don't think they can just leave the investors in these preferreds without some way of getting out. What are the reputational implications to a firm like PIMCO if they don't give these investors a way out? I suspect these funds will have to call these preferreds or list them on an exchange. And I don't think these preferreds are large enough to justify the cost of a listing. These funds don't have a lot of options for funding. Banks are not going to step up. My guess is that these funds will eventually be forced to eliminate their leverage and sell bonds into a falling market. When that happens, we might find a bottom in the muni market.

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