Municipal Bonds Are the New Junk

[flashl]

Say It Ain't So, Municipal Bonds Are the New Junk: Joe Mysak

Feb. 1 (Bloomberg) -- You can well imagine my surprise when looking for the next thing to blow up in the credit markets, I was informed it would be municipal bonds.

There it is: Municipal bonds -- the New Junk.

You should be skeptical when an entire asset class is trashed, especially one where most of the securities involved finance essential purpose stuff like roads, bridges and airports. But hear the skeptics out. Their prognostications, shrieks and dire warnings will soon be broadcast far and wide for the delectation of thrill-seekers everywhere.

Keep in mind that, except for the people actually in the market, like issuers and underwriters, and the 4.5 million taxpayers who claim tax-exempt interest (and maybe not even them) there is a national, cultural bias against municipal bonds.

That's because bonds are boring, and bonds sold by states and localities are boring and also complicated in terms of how they are put together and what secures their repayment. Plus, compared with the stock market, there's limited upside.

There's unlimited downside risk, though, as the critics will tell you. Run! Here come the bears!

Bloomberg

[Warpy]

1. yeah, I know, but mine are maturing

and the interest is tax free. I will probably be looking for somewhere else to stash the boodle as they mature.

Fortunately, I transferred them all from Florida to NM when I inherited and this state is solvent, unlike post Jebbie Florida.

[A HERETIC I AM]

2. A careful reading of the article shows the author does not share the same sentiment as the person he

quotes.

There's this;

The real problem, though, as Sedacca sees it, is the leveraged closed-end municipal bond funds. Closed-end funds have a limited number of shares, and enhance their returns by borrowing money through the sale of floating-rate securities to buy more bonds. The funds are being forced to pay more in the short-term market, Sedacca points out.

And there's this;

I am by nature skeptical of the skeptics, and what's more, like to see what happened in the past. I agree with Sedacca that if you're in the municipal market, you had better know exactly what you own, if only for your peace of mind. But the market itself is a lot more flexible than critics calculate. Property taxes decline: municipalities reduce spending. Auction rates rise: issuers sell fixed-rate debt.

If you own municipal bonds, time is on your side.

underline and bold emphasis mine.

Lesson? Stay out of Closed End Muni Bond funds. If you are in or looking at an Open End Muni Bond fund, learn about it. Find out what they hold, what the average credit rating is, the yield and the average duration.

Just because the market prices down a particular bond because an insurer has been downgraded, it is NOT an automatic indication the issuer of the bond is more likely to default.

[flashl]

3. Excerpts from Bennet Sedacca article

Municipals are deemed to be the safety net of many portfolios and this may not turn out to be the case.

The Municipal Bond Insurers, The Latest Bailout

The municipal bond insurers like MBIA (MBI) and Ambac (ABK). I have no idea if the smaller insurers like FGIC, FSA and ACA Financial own them, but they have other problems of their own. A recent report by Barclay’s indicates a likely downgrade of FGIC, which insures over $300 million in bonds.

There has been much press about a bailout of MBIA and Ambac by a consortium of commercial banks that would include a $15-20 billion cash infusion. It would be very dangerous to let all of the bond insurers fail because it may cause the municipal market to go into disarray and thus increase borrowing costs for many issuers. What bothers me is that the banks in this bailout are the same ones that have been writing down sizable chunks of book value and then, hat in hand, go to Singapore, Kuwait, the UAE and China to recapitalize themselves.

So the poorly capitalized banks that had to beg for capital are now going to use that capital to bail out the insurers, whose business models were flawed to begin with?

...

If I owned a large portfolio of municipal bonds, I would do a lot of homework on the underlying credit ratings of the issuers and the stability of the issuer. If I had to own municipal bonds, I would own only ‘pre-refunded’ municipal bonds. Pre-re’s, as they are known in the industry, are usually backed by U.S. Treasury and sometimes U.S Agency securities. The problem with pre-re’s is that they are ‘priced for perfection.’

...

The Potential Far-Reaching Effects of Fallout in the Municipal Market

In summary, there are a few major issues within the municipal bond space. First, holders of municipal bonds are often retail investors who have relied on the bond’s insurer and blissfully buy bonds because they are ‘AAA and insured.’ Having spent 15 years in the bond sales and trading game, I know this is the case. Many institutions do indeed look at underlying ratings before buying bonds, which is more prudent. But a serious down draft in prices could have a far reaching impact for investors.

Municipals are deemed to be the safety net of many portfolios and this may not turn out to be the case. Further, the cost of borrowing could rise, perhaps dramatically depending on the credit, causing profit margins to shrink. This will likely be a fluid market that I will look to take advantage of, possibly in both directions. I think it would be a good idea for investors to stress their holding of both individual municipal bonds, open end funds, and in particular, closed end funds.

Minyanvile News

It's two-pages long but very detailed and he explains those closed-end funds.

[A HERETIC I AM]

5. I agree with his concerns completely

Some of the Closed End funds I have seen have been pretty scary, to be honest. And he is VERY correct about the fees and the way they are priced. An issue will be offered with a projected NAV of say $20.00 but with a selling concession of up to $.60/share (sixty cents) and even higher. The INSTANT the fund starts trading the market prices it down to reflect the selling concession. That's just for starters. If you happen to have had some of these funds sold to you when they were first issued, your yield looks great ("How does 10% sound?") but it is almost certainly unsustainable. Put $10,000 into a fund like that and your NAV has slid so much that even though it is paying $1,000/year in interest/distributions, the share price has fallen out of bed and your statement shows a big ass loss.

Here is a good example, though it is not a Muni Bond fund: DHG

That Morningstar Snapshot says the NAV is $15.26 but it closed today at $13.79. (It was up eleven cents today) Thing is, when it was issued back in December of 2006, it was priced at $20.00! It spiked up over the next couple weeks to a high of $21.75 but if you didn't get out of it right then, you've watched your principal erode rather dramatically. Sure, it's yielding 11.56% and is paying a $1.595 dividend but if you put ten grand into it the day it began trading and reinvested the 4 quarterly dividend payments received in 2007, your position is now worth around $7,515!*

Sedacca has very legitimate concerns that I would not argue with but he was not completely dour. His point about knowing or understanding the underlying credit rating of a municipality as being MORE important that the rating given a bond merely because it is "insured" is something worth noting.

Investors in Muni bonds should also keep in mind the percentage of Muni defaults is actually very small. Tiny, even.

*This is how I arrived at that figure; A $10,000 investment of a fund priced at $20.00/share equals 500 shares. 500 shares of the fund priced at $13.79/share (todays price) equals $6,895. 10000 - 6895 = 3105 (represents the loss of principal). That fund pays a $1.595 per share dividend. 1.595 X 500 = $797.50 per year in dividends. If you had reinvested the 4 dividend payments received during the course of 2007, you would have purchased an additional 45 shares (roughly, depending on the share price on the Ex-Div date each quarter) In all fairness to that particular fund, all of the above is based on the performance for only 13 calendar months. It could just as easily climb back up this year. I do not own any of this fund (thankfully) and I make no recommendation as to its suitability as an investment. For informational purposes only.

[Robert Oak]

4. $2.3B write down yestereday

and MBIA stock raise 8%. I was like, ok, reward for bad behavior? What?