Fading The Hype In Municipal Bonds

Many analysts and investors still haven’t quite figured out that just because the spread between municipal and Treasury bond yields is relatively wide, that doesn’t mean municipal bonds are a “buy.”

Instead, it largely reflects the fact that municipal finances are in a shambles and, because of still-deteriorating fundamentals, they are headed further south (even if, as many expect, revenue-strapped state and local governments are set to join Washington’s bailout parade).

Still, it appears that not everyone on Wall Street is out of touch with reality. According to the Wall Street Journal’s MarketBeat blog, in a post entitled “Muni-Bond CDS Spike,” some smart money types are betting against the “they’re cheap” hype.

In recent weeks investors have been more actively buying insurance against holdings of municipal bonds, reflecting increased concern about the outlook for state and local budgets in coming months.

It comes at a time when budget deficits are projected for 38 states for the upcoming fiscal year, and as bond issuance has slowed to a trickle, municipalities are finding themselves cash-strapped. That’s resulted in a rise in the cost of insuring certain muni bonds against default, though these spreads have declined a bit since Christmas. After all, they don’t have many other choices in terms of raising funds.

“They have four sources of revenue: real estate tax, income tax, sales tax, and hidden fees,” says Diane Garnick, investment strategist at Invesco. The first three, she says, are politically and economically difficult to swallow, which leaves the latter, made up of lotteries, speeding tickets, and other such things. It’s no wonder states are struggling.

According to data from UBS, general obligation bonds from the state of New Jersey had an insurance cost of $250,000 as of Tuesday. That’s down from a recent high of $330,000, but still higher than the 90-day average of $192,000. New York’s general obligation bonds are at $320,000, down from $365,000, but higher than the $238,000 average.

California’s bonds peaked a few weeks ago, hitting a high of $475,000, but had averaged $258,000 over the past 90 days. Currently, indexes tracking credit-default swaps in various asset classes show a belief in more risk on the muni side than on the corporate side.

Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research, says the stimulus plan as proposed by President-Elect Barack Obama could clamp down on investor fears, as state and local municipalities are expected to benefit from such a package. And with triple-A rated 30-year muni bonds offering a yield of 5%, compared with the 3% yield on the 30-year Treasury bond, some see muni bonds as a good value.

“An Obama administration will quickly be confronted by the need to provide those hundreds of billions of dollars to states and large municipalities,” writes William Gross, chief investment officer at Pimco, in his January commentary. “Their requests total nearly a trillion dollars and to think California or NYC would be allowed to fail is, well - unthinkable. Municipal bonds then, selling at historically high ratios relative to U.S. Treasuries, offer attractive price appreciation potential, or at the very least a defensiveness with high carry that a 2½% 10-year Treasury cannot.”

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