Is Fear Of Default Priced Into Muni Yields?

Take a look at these state specific muni yield curves. Does CA look like it has “fear” priced into the yield curve. CA is on the verge of collapse and the munis seem to be humming along like it was a beautiful sunny day. I don’t get it. This market is not reflecting the reality of what’s actually taking place.

Part of the low yields could be explained by the “Build America” Bonds. These bonds permit municipalities to offer taxable bonds at higher rates and received a 35% rebate on the interest costs from the Fed Governement;

• (Per WSJ Article) - Part of the American Recovery and Reinvestment Act, Build America Bonds offer a 35% rebate from the Federal government to issuers on their interest payments. This means that issuers can offer higher rates on their debt than they typically would be able to afford, and so take their offerings into the taxable bond market.

  For taxable-bond investors, the attraction is primarily diversification as muni bonds are an area that they rarely have exposure to.

  Mr. McGregor said he expects Build America Bonds issuance of between $50 billion to $75 billion a year. The entire municipal-bond market saw issuance of $400 billion last year. And because most Build America Bonds are issued for debt of 20 years and longer, said Mr. McGregor, their real effect on the market isn’t fully reflected in those numbers.

  As well as easing the fundamentals of the muni market, Ms. Thompson said the move by muni issuers to the taxable market could help muni investors in other ways. “One of the frustrating things in the muni market is that the financial disclosure practices are not as regular and thorough as in the corporate debt market,” said Ms. Thompson.

The converse side of “Build America Bonds” is that by holding prices higher, due to artificial government subsidies, funds are not flowing into municipal bonds as readily as they would without the subsidy. If there were not “Build America” bonds, then the muni curves overall would be higher and rates would be higher. The higher rates would entice more buyers into munis and more funds would flow to municipalities. It seems that this is all part of the USA’s grand plan to keep rates low to artificially support the stock market. If you could get 7% tax free on munis, why would you own stocks ?

Higher interest rates will suck money out of risky assets and put them into bonds. This is not what the Obama administration desires.

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