What in God's Name is Going on in the Muni Market?

One of the reasons I have always enjoyed being involved in the high yield and distressed debt markets is the ability to really dig through things that have been completely beaten down and no one wants to touch.

In early 2008, there were a series of event that lead to a number of well regarded municipal issuers having to pay 10-20% on their auction rate securities. We bought as much of the vanilla issuers as we could- after it was announced that Warren Buffett was doing the same thing, the trade stopped working as municipalities got smart and started terming out their debt.

Well today, a friend emailed me, and told me to look at the charts on a number of levered muni closed end funds. Have you see these charts? Let's pull up the old 4x1 Bloomberg Graph, comparing with ETF and three different closed end muni funds:

For reference:
  • MUS: BlackRock MuniHoldings Quality Fund
  • PML: PIMCO Municipal Income Fund II
  • FMN: Federated Premier Municipal Income Fund
  • HYD: Market Vectors High Yield Municipal Index ETF
I thought to myself - it has to be the move in the treasury right? So I added the 30 year treasury bond to the graph:

As you can see, the sell off has been significantly more dramatic in the closed end and muni ETFs relative to the long bond. So what is going on?

I do not regularly invest in this market unless there is at least a little blood in the streets - little did I know there is a lot of blood in the streets. The muni markets was hit with a perfect storm of negativity over the past few weeks:
  1. A huge supply calendar: JP Morgan notes that next week could be the record for muni supply coming to market IN U.S. HISTORY (my emphasis added)
  2. Republicans win election means state budgets get less support from the federal government which means increasing stress on ability of municipalities to pay (and certain muni provision as part of President Obama's stimulus bill that need to be re-upped)
  3. Everyone and their mother front-running the Fed and the subsequent unwind (compounded by the unwind of the long end of the Treasury curve as well)
  4. Leverage, leverage, leverage. Most of these closed end muni ETFs are levered one way or the other. Further, and I really cannot believe they still exist after the debacle that was 2008, municipal arbitrage hedge funds probably were probably crushed with the recent moves in the curve. Borrow short to invest long? Even with hedging via swaps and swaptions, imbalances between the muni curve and treasury curve arise and when you are 20x levered disaster can strike.
  5. Concerns over BABs expiration: If you didn't know, the Build America Bonds program expire on December 31st. Issuers want to sell as much paper as possible to avoid the chance the interest credit gets removed - again more supply on the market.
  6. Muni mutual fund flow is nill at best: According to AMG, approximately $45M has been put to work in the last two weeks in municipal bond funds. The average weekly inflow this year is over $650M.
  7. The economy and general risk concerns (i.e. Allied Irish Bank, Asia raising rates, etc)
As would be expected in such an environment, the credit curve for tax exempt bonds is steeping - and FAST. We are talking unheard of moves.

But what is an investor to do in this sort of environment? I say average down. Supply is going to continue to stay high until clarity on BABs/Stimulus Provision (specifically the AMT provision - muni's issued in 2009/2010 are exempt from property and casualty insurers which are large buyers in this space) and demand will be tepid. I personally will be dipping my toes in some of the closed end New York muni funds (PNI, EVY, etc) sporting 6-7% yields (nearly 10% taxable equivalent). Hell - I live in New York - and if this ship is going down, I'm taking my tax exempt bonds with me.


Anonymous,  11/17/2010  

keeping abreast of interesting developments in the credit markets is what keeps me reading your blog. Great stuff!

tom brakke 11/17/2010  

For many of the closed-end funds, the change in the market price to NAV relationship as psychology has morphed has been a factor -- the closed-end trap.

Anonymous,  11/17/2010  


don't forget that many of these muni closed end funds were trading at stupid premiums to their NAV so while the underlying muni market has taken a step back the decline has been nothing like the charts would imply.


Anonymous,  11/17/2010  

One more reason: the heat-seeking momo traders smelled blood and treated these cefs like spec stocks, with 5% moves per day. They forgot that there are underlying assets and dividend flow and that they are unborrowable. I bought at 7-8% current yields and large discounts to NAV.

Anonymous,  11/18/2010  

you've all missed the real point. That is, AMBAC filing for BK. Look at the calendar, and look at the sell off. Dumping of any and all muni debt with insurance spiked. Take a gander at the insured etf's. They got their teeth kicked in. Given the states dire straits, that rhymes by the way, and the republicans having no choice to but to act tough for the T partiers, you think bailing out glamorous Cali or NY will sit well in the fly over states.. no chance. That my friends, is whats going on.

Anonymous,  11/18/2010  

Hunter - Have you heard Meredith Whitney's thoughts on the coming wave of municipal defaults?

Tax-free or not, the dividend might not be paid in a couple of years

Anonymous,  11/23/2010  

There is significant default risk in the Muni market, but I think it is contained to the general obligations. The revenue bonds should remain steady.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.