How Risky are Municipal Bonds?

Easily one of the most "popular" topics in my client meetings these days is municipal bonds.

I have written several posts over the last few weeks about municipals. I strongly believe that while there are doubtlessly some municipal credits that should be avoided, in general munis are one of the most attractive segments in the capital markets these days.

This seems to be a minority opinion, however.

Indeed, while munis are a source of worry for my clients, no one has any serious problem with either stocks or corporate bonds (a complacency which may be a cause for concern, but that's another story). Hence the reason I often spend more time discussing municipal bonds.

Meredith Whitney is one of the reasons that munis are under such pressure.

Ms. Whitney appeared on the television show 60 Minutes in December to announce that the municipal market was facing "hundreds of billions of dollars of defaults" in the coming months. Since she had been quite prescient in seeing the major problems facing the U.S. banks in 2007, her comments received a lot of attention.

Most of the major municipal bond dealers, as well as numerous trade groups, have come out with voluminous reports essentially debunking Ms. Whitney's work. Some of the attacks seem almost personal, which has lead other commentators to try to defend her analysis.

Problem is, Ms. Whitney has refused to publish her research that supports her dire predictions, although copies are apparently leaking out. In addition, she declined an opportunity to appear before a Congressional subcommittee to go over her thoughts in more detail.

Many are now suggesting that she is motivated less by her concerns about municipal bond investors than her desire to build her own business.

Here's an excerpt from an article in Monday's New York Times discussing the controversy:

“We believe the financial challenges facing states could be the next systemic risk within the U.S. financial markets,” {Ms. Whitney} wrote in the report, a copy of which was provided to The New York Times. Ms. Whitney also draws comparisons between the risk-taking on Wall Street and the budget practices at many state governments.

In fact, there are important differences between the problems facing states and municipal governments, bad as they may be, and those the banks encountered during the financial crisis.

For starters, states have the power to raise taxes — something private companies with a shortfall cannot do, Mr. Rosner of Graham Fisher said. They can also try to force concessions from their workers in terms of reduced pay and benefits, in some cases.

Even if municipal issuers run into distress, a financial control board can shield bondholders from a default, as happened recently in Nassau County. These boards usually create a so-called intercept, or a structure that can grab new tax dollars as they come in, before they can go into the locality’s general fund. The money goes into a special fund to pay the bondholders their interest and principal, a system that prevents elected officials from spending it on other things.

Meredith Whitney’s Muni Bond Prediction Draws Scrutiny - NYTimes.com

Is the Fed Really Responsible for Rising Commodity Prices?

I've been reading "The Financial Crisis Inquiry Report". This 650 page missive is the end result of the Financial Crisis Inquiry Commission's 18 month investigation into the financial meltdown of 2008.

This may sound kind of nerdy (can't you find a compelling novel to read, Dave?) but the report really is pretty interesting.

I'll be writing more about this in the next few days, but one of the aspects of the report that is particularly striking is the fact that there is no "smoking gun" which points out the persons or institutions that were responsible.

No, as the old expression goes, "We have met the enemy, and it is us".

All of us - investors, homeowners, government officials, rating agencies - were involved in the fallacy that home prices were destined to go up forever.

Warning signs abounded for much of the last decade, but they were ignored. Debt levels soared to unimaginable heights, but no one seemed to care.

And when the Day of Reckoning came, no one was spared, and we are now left with one of the biggest financial hangovers in modern history.

Today, however, everyone seems to know who to blame for soaring commodity prices and the weak dollar: Ben Bernanke and the Fed.

While it is easy to bash the Fed (although I personally think that Bernanke is doing a pretty good job), many of the economic events that surround us are not the responsibility of the central bank of the United States, as this recent article from Fortune magazine points out.

Here's an excerpt:

The true stars of the story of rising copper, corn and livestock prices are rising incomes and growing appetites in Asia and other emerging economies. That combination stokes robust demand for goods and raw materials that doesn't fade with rising prices. Also making an appearance are foreign politicians crossing their fingers and hoping, as policymakers often do, that the party will wind down without anyone having to actually yank away the punch bowl....

..."You can't blame Bernanke for the Russian drought or the cotton crop failures in Asia," said Howard Simons, a strategist for Bianco Research in Chicago. "More money does create an inflationary environment, but rising commodity prices can't be totally blamed on the creation of money."

The Bernanke-bashing bubble - Street Sweep: Fortune's Wall Street Blog

Should Investors Be Concerned About Egypt?

Last week I sold most of my emerging markets exposure in my client accounts.

Don't get me wrong: I'm a big believer in investing in the fastest growing parts of the globe. Not only are countries like Brazil, South Korea, and, yes, China, posting very strong economic numbers, but their demographics (i.e. lots of younger people) bode well for growth in the years to come.

That said, I think that most would agree that the ride to prosperity in the emerging markets will not be a smooth one.

I think of investing in the emerging markets as investing in California in the early part of the 20th century: the future looks bright, but there will be many periods that it makes sense to step aside.

I think that the current time is one of those periods. I don't know what how the outcome of the unrest in Tunisia, Egypt, etc. will turn out, but I think we're seeing backlash between the huge wealth being created in relatively poor countries that are only benefiting a tiny fraction of the population.

This weekend's Financial Times had a good piece about the emerging markets written by columnist John Authers.

After noting that although there has been a modest outflow from emerging markets mutual funds, most of the market indicators indicate an overall calmness.

Indeed, there seems to sense of complacency, if not ennui, with scenes of thousands of Egyptians throwing rocks at representatives of an American-backed government.

However, Mr. Authers notes that at other times of crisis in the Middle East - the Yom Kippur war of 1973; the Iranian hostage crisis of 1979; and the invasion of Iraq in1990 by Saddam Hussein - the markets reacted in a very similar fashion to today. Initially there was a sense of denial, but eventually reality hit investors, and the markets took a tumble.

As Mr. Authers concludes his column:

Investors should still look at the underlying driver of discontent in the Middle East. Rising food prices are destabilizing many emerging markets on which the world relies for growth and have prompted equity investors to move to the exits. Low western interest rates add fuel to this fire. And oil is reaching prices that could damage even the less oil-addicted modern economy.

Therefore, it is still a concern that the markets in need of an excuse to sell off have instead opted to ignore a pressing reason for one.

I hope I am wrong, but I would rather err on the side of caution on this one.

http://www.ft.com/cms/s/0/4c6fae94-30cb-11e0-9de3-00144feabdc0.html#axzz1DHLAwOKP

What are the Charts Saying About the Markets?

I went to hear Mary Ann Bartels, chief technical analyst at Merrill Lynch yesterday.

Mary Ann been looking at charts for Merrill for a number of years now, following in the footsteps of such market analyst legends like Bob Farrell and Dick McCabe. While she's not always right on the markets (a point she is always quick to note in her presentations), I think she's had a pretty good track record, so she's certainly worth a listen.

Any good technical analyst - and I would include Mary Ann as part of this group - does not try to force their particular views on economic or company fundamentals to determine their opinions. Instead, by looking for trends in price patterns, they try to let the markets tell them what the future holds.

(By the way, I realize that many academicians scoff at technical analysis, claiming that it is no better than "voodoo". That said, most of the best portfolio managers I have met over the course of my career spend a good portion of their time looking at charts.)

Mary Ann's overall message was pretty bullish for 2011. She has a year-end target for the S&P 500 of around 1400 (which would be +7% from here). Her favorite sectors are energy (by far); consumer discretionary; and technology. She would avoid healthcare; financials; and the utilities sectors.

Interestingly, although she is bullish on stocks, she also believes that interest rates remain in a downward trend, so bonds remain a buy. Her work would suggest that U.S. Treasury 10-year notes have not yet reversed the secular downtrend began in the 1980's. While she would not be surprised to see the 10-year move to around 4% at some point (it is around 3.60% at this writing), she still thinks that we will once again test the lows in yields that we saw last year, which would imply 2.30% or so.

Mary Ann remains very bullish on commodities, especially copper. She thinks that gold remains in an uptrend, with a target of at least $2,000, although this is a longer term target.

One cautionary note: the transportation stocks have been weak recently, although the broader market averages have continued to move higher. This is a classic Dow Theory warning signal, and could project into some near-term market weakness. However, to Mary Ann, any pullback should be used to add to stock positions.

Warm thoughts on a cold winter's day.

Did Congress Fuel the Mortgage Debt Crisis?

One of the main reasons that I worry that the U.S. is going to be in for a long period of sluggish economic growth is the huge hangover of debt that remains after the last couple of decades.

The numbers are staggering, from the $14 trillion federal government debt to the trillions owed by mortgage borrowers.

Many of my clients (as well as the Chinese government) believe that the Fed is trying to reignite inflation to get us out of our collective debt hole. Even if this is truly what the Fed is trying to accomplish (which I doubt), I remain skeptical that they will be successful.

If you go back over the last, say, 150 years, you will be hard-pressed to find a industrial country that was able to inflate its way out of its debts. Instead, the example of modern Japan seems more relevant, where low interest rates, disinflation, and sluggish economic growth are the norm.

In any event, Bethany McLean had a good piece in the on-line magazine Slate about all of this, and the overwhelming debt burden that needs to eventually be repaid.

She makes an interesting point. Much of the debt explosion started in 1986, when Congress eliminated the tax detectability of interest for any debt other than mortgages. Didn't take long for Americans to figure out that borrowing against the equity in their homes was the best way to go, especially in the last decade (I have added areas of emphasis):

The numbers in the commission's report chart the surge in housing-related debt: "By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996." Of course, all of this came at a cost: "Overall mortgage indebtedness in the United States climbed from $5.3 trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years from 2001 to 2007—more than 63%, or from $91,500 to $149,500—as it had over the course of the country's more than 200 year history." This was during a period when overall wages were stagnant. To cut the figures a different way, as the commission helpfully does: Household debt rose from 80 percent of disposable personal income in 1993 to almost 130 percent by mid-2006. More than three-quarters of this increase was mortgage debt. Did all this debt hurt economic growth? On the contrary, it supplied it: "[B]etween 1998 and 2005, increased consumer spending accounted for between 67% and 168% of GDP growth in any given year.
FCIC report: Wall Street's debt problem is different from yours. - By Bethany McLean - Slate Magazine

Ms. McLean goes on. Once Main Street figured out that mortgage debt was a great way to borrow and spend, it didn't take long for Wall Street to leverage up their balance sheets, buy and then package all of these mortgages and make boatloads of money for themselves.

Problem is, of course, is that too much of a good thing eventually comes back to bite you, and that's what seems to be happening now.

Muni Selling Pressures Create Opportunities

When investing in bonds for my clients, there are two themes that I keep in mind.

First, I continue to believe that the bigger risk for most investors is that interest rates could move lower, not higher. Yes, I understand that commodity prices are moving higher, but I still think that the overall economic picture is one of disinflation, if not deflationary, trends.

The second theme I am following is that I believe that municipal bonds are extremely attractive relative to most other alternatives in the capital markets. I understand the huge financial problems facing state and local governments, but I also think that solutions will be found.

To be honest, however, most clients do not agree with me on either theme.

The overwhelming consensus opinion is that interest rates will be moving sharply higher sooner rather than later. Most cite the huge federal budget deficits, combined with very generous Fed policy, as reasons that the "bond market vigilantes" will eventually demand higher rates.

However, municipal bonds have been very much in the news, and investors in municipal bond funds have been fleeing the sector.

A recent column written by Randall Forsyth in Barron's cites some work done by Barclays Capital which points out that investor fears on municipal debt has driven municipal bonds guaranteed by corporate borrowers to higher interest rates than taxable bonds issued by the same corporate borrower.

Here's an excerpt:

For instance, the Barclays analysts found a Dow Chemical (DOW) IDR due 2033 yielding 6.25% tax-free while a Dow corporate due 2029 yielded 5.67%. The chemical company's debt is rated triple-B-minus by Standard & Poor's, a single grade above junk. Other Dow IDRs yield from 58 basis points 172 basis points above comparable Dow corporates. (A basis point 1/100 of a percentage point.)

An International Paper (IP) tax-exempt IDR due in March 2014 yielded 3.50%, above the 2.94% on the taxable bond due June 2014. Their ratings Baa3 by Moody's, its lowest investment grade, and triple-B by S&P


Some Muni Yields Exceed Similar Corporates - Barrons.com

So not only are municipal bonds yielding more than Treasurys across most of the maturity spectrum but munis are often yielding more than corporate bonds of the same credit.

In my opinion, such indiscriminate selling usually spells opportunity, and I think the muni market today represents a good buy.

The Markets at the Beginning of February

Good column this morning about the current market environment by Richard Milne in the Financial Times.

The consensus view is that stocks should have a good year in 2011. Corporate earnings are improving (despite lackluster sales growth); Fed policy remains extremely friendly; and alternative investments like bonds offer only modest returns. Moreover, historically the third year of a presidential cycle nearly always has offered investors attractive stock market returns.

At the same time, there are enormous problems still remaining in the economy.

Unemployment rates are very high, and there is little prospect that employment will increase dramatically any time soon (a fact even acknowledged by Treasury Secretary Geithner last week). Housing remains a mess, and probably will be for several years.

Municipal and federal deficits are unsustainably high, and will need to be addressed at some point in the very near future through some combination of higher taxes and lower spending, which will act as a drag on economic growth.

So what's an investor to do?

My own opinion is that you have to stay invested, particularly for the first part of this year. Valuations on quality large cap companies in particular stand out as appealing, not to mention the fact that dividend yields on many of these stocks are far higher than bonds issued by the same companies.

But around mid-year I think investors would be wise to heed the advice of Jeremy Grantham of the investment firm GMO.

Mr. Grantham is one of the more astute investment strategists out there, and he is always worth a listen. Here's today's column in the FT reports that his most recent strategy piece contains the following advice:

So what are investors to do? In Mr. Grantham's latest note called "Pavlov's Bulls" - about how the market salivates on cue ahead of any promised government stimulus - he warns that "you are living on borrowed time as a bull" with the S&P 500 worth only 910 rather than its current level of 1,280. His advice? "The speed with which you should pull back from the market as it advances into dangerously overpriced territory this year is more of an art than a science, but by October 1 you should probably be thinking much more conservatively."
FT.com / Markets / Insight - Why investors have adopted teenage temperaments

I would add one final point. In a world where unexpected events can change the investment landscape dramatically in a heartbeat (e.g. as I mentioned yesterday, we are watching events in Egypt very closely), a diversified portfolio makes more sense than ever.