Wednesday, January 4, 2012

Don't Worry, Whitney - Lots of Bond People Got 2011 Wrong

Municipal bonds turned in a very strong performance in 2011.

Here's what John Hallacy, a municipal bond analyst at Merrill Lynch, reported last week (I added the emphasis):

The BofA Merrill Lynch Municipal Master Index returned 11.189% for 2011. This compares with total returns of 9.185% for the US Treasury/Agency Master Index,7.507% for the US IG Corporate Master Index and 4.501% for the US Corporate High Yield Index, for the year. The best performing munis were on the long end ofthe curve and A- and BBB-rated credits

http://rcr.ml.com/Archive/11122140.pdf?w=dglen%40bpbtc.com&q=EWmIeUQlxyP!QB77ytkdwA&__gda__=1325695582_47206218ea7e0b4edf8917d2d4287734

One of the big reasons that municipals did so well last year occurred on December 14, 2010.

The CBS news program 60 Minutes interviewed a Wall Street analyst named Meredith Whitney.  Ms. Whitney - whose claim to fame was correctly calling the massive problems in banks stocks in 2007 - suggested in the interview that we could see "50 to 100 sizable defaults, {maybe} more" in the municipal bond market in 2011.

Predictably, municipal bond investors panicked, and headed for the exits at the end of 2010, and municipal bond yields soared.

Now, as we all know, the rate of default in 2011 was actually slightly lower than 2010, and those same investors who had fled the municipal bond market returned with a vengeance, driving municipal bond prices higher and producing the strong returns noted by Merrill  Lynch.

Whether Ms. Whitney actually predicted huge municipal bond defaults in 2011 is open to question. Writing in the November 2011, Vanity Fair financial writer par excellance Michael Lewis reviewed the transcripts of the CBS interview, and found that what Ms. Whitney actually said was that municipal bond credit worthiness would continue to deteriorate in 2011, which in fact has proven to be the case.

But that hasn't stopped Wall Street and municipal bond managers from telling all who would listen that they had been right, and Meredith Whitney was wrong.

Yet as I thought about it, I don't really think any economist or bond manager should be proud of their record in 2011.

For example, few, if any, economists forecasted interest rates falling to 60-year lows by the end of 2011.

Many bond managers thought that high yield bonds were a sure bet in 2011 ("just look at the high levels of corporate cash!") but as the Merrill Lynch piece indicates, high yield was the poorest performing sector of bond market.

And what about Bill Gross - the most successful bond manager of our generation - pulling client money out of the Treasury bond market in mid-2011, only to miss the huge rally in the wake of the European-induced flight to quality?

Where was the "smart money" when S&P downgraded the credit quality of the US government in August?  Other than nodding sagely about the irrationality of Washington, few bond managers had the courage to add to positions.

I could go on, but you get the point.  Forecasting is generally a fool's errand - it's usually only a matter of time before events prove predictions wrong.

Or, to put it another way, Ms. Whitney was not alone in proving her fallibility in 2011.