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Are Municipal Bonds a Ticking Time Bomb?

Are Municipal Bonds a Ticking Time Bomb?
By Ron DeLegge
December 13, 2010

SAN DIEGO (ETFguide.com) – If there’s one great thing you could say about low interest rates it’s that they’ve given a lot of over indebted states time to get their financial house in order. That’s the good news. The bad news is that states, even with the help of rock bottom borrowing rates, are still spiraling.


Is the municipal bond market a ticking time bomb? Let's analyze the situation.

Wall Street’s Three Musketeers
The failings of today’s U.S. credit rating regime, a monopoly of three musketeers, are no secret. A lack of foresight by Fitch Ratings, Moody’s and Standard & Poor’s along with pressure from Wall Street’s aggressive underwriters to assign high ratings to unworthy debt led to billions of dollars in mis-rated mortgage bonds during the 2008-09 financial crisis.

These massive conflicts of interest that contributed in part to the crisis continue to plague the entire bond market, including the way municipal bonds are rated.

In April, California’s $68 billion of general obligation bonds were moved up from BBB to A-minus by Fitch Ratings despite the fact the state’s fiscal situation is worsening. Granted, A-minus is still the lowest credit rating among 50 states but does it really accurately reflect the danger of lending money to a fiscally challenged state like California?

Fitch used the occasion to explain that California’s credit rating wasn’t really upgraded but rather a series of “adjustments to denote a comparable level of credit risk as ratings in other sectors.”

Maybe it’s asking too much but any “adjustments” or “improvements” in the way credit ratings are assigned shouldn’t result in a favorable score for questionable borrowers. Simply put, credit ratings have followed the same general path as boat building: Amateurs built the Ark but experts built the Titanic.

New Animal: The Tie-Dyed Swan
Nicholas Taleb, a hedge fund manager, popularized the Black Swan Theory in his attempt to explain the existence of unforeseen and unpredictable high impact events. However, classifying future municipal bond defaults as “Black Swans” is probably a stretch. While such occurrences have been rare historically speaking, they aren’t entirely an unknown occurrence which would make them something else.

As such, a new animal, the “Tie-Dyed Swan” might be the best description of today’s munibond market.

A person could safely argue the flat year-to-date returns for heavily indebted states like California (NYSEArca: CXA) and New York (NYSEArca: INY) are hardly reflective of their underlying fiscal crisis. Complacent munibond investors this time around may be taken surprise by swans with changing colors. (Please don’t mistake these particular swans for the multi-colored peacock used by a certain financial network.) While the tax benefits of owning munibonds have been thoroughly extolled, their true credit risk hasn’t. 

Conclusion
How far will the crisis of overleveraged states go? And will it spill over into other credit markets? What kind of financial risk is mis-rated munibond debt causing? And will this turn out to be the federal government’s next bailout?

In July when munibonds (NYSEArca: MUB) were still on a roll and most credit analysts believed the worst was over, ETFguide’s ETF newsletter warned: "The state of California's $20 billion budget shortfall sets the gold standard of what's become fiscal perversion among state and local government everywhere. The only other place with more financial incompetence per square foot is Washington D.C. Tax revenues are drastically own, yet expenses keep rising at an astonishing pace.” Beyond that, it covered profit opportunities and strategies for capital protection in the face of the coming hurricane. Are you ready?  

CommentsAdd Comment

Ron said on December 14, 2010
  Fred,

Points well made but with all due respect, higher munibond prices can only come based upon two scenarios: 1) Lending demand usurps the market's expectations and suddenly jumps and/or 2) Interest rates fall from these already dungeonous levels.

Also, the issuance of new bonds, while it continues the flow of capital for state and muni governments to operate, is dwarfed by the level of existing debt that needs to be refinanced. The fact that many of these borrowers have a worse credit situation than when they initially borrowed suggests these heavy debt loads will be refinanced at higher rates, thus pushing down the value of the bond or income stream.
 
 
Fred said on December 14, 2010
  Many muni experts contend that the heavy BABs issuance over the past few months actually represented debt that might have otherwise been issued next year. Thus, even if the BABs program is extended, total muni bond issuance is likely to be lower, not higher, next year, which would support higher bond prices as well as increase the value of existing bonds.
 
 
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