Bad Year For Muni Bonds
Kurt Brouwer December 19th, 2007
It has been a tough year for municipal bonds (also known as tax-exempt bonds). The credit crunch stemming from the subprime lending mess has had consequences that even extend into public finance. Wall Street firms and banks have dumped municipal bonds from their own trading accounts in order to deal with losses on mortgage-related debt. Other big investors in muni bonds also pulled back and, as a result, yields rose. And, as always with bonds, yields and prices move in opposite directions. When yields go up, prices go down. This article from Bloomberg spells out what has happened [emphasis added below]:
Muni Bonds Swoon With Worst Total Returns Since 1999 (Bloomberg, December 19, 2007, Michael Quint & Jeremy R. Cooke)
‘Wall Street’s three-year love affair with debt sold by U.S. states and cities is over.
Municipal bonds, whose returns trounced Treasuries and corporate debt from 2004 to 2006, are headed for their worst year since 1999, according to Merrill Lynch & Co. indexes. They may remain laggards after securities firms reduced their holdings during the third quarter by the largest amount in at least 12 years, data compiled by the Federal Reserve show.
Citigroup Inc., Goldman Sachs Group Inc. and the rest of the securities industry reduced holdings of municipal bonds in their trading accounts by more than 16 percent, to $45 billion as of Sept. 30 from a record $53.9 billion at the end of June, according to the most recent Fed data released Dec. 6. The sales raised yields on municipal debt relative to Treasuries and increased financing costs for state and local governments planning bond sales by as much as $320 million through 2017.
“There’s no money flowing into the market right now from hedge funds, banks or anywhere else,” said Thomas Metzold, manager of the $6 billion Eaton Vance National municipal fund in Boston. “The banks have other needs for their capital.”
Subprime Damage
Securities firms are putting less into state and local debt after about $62 billion of writedowns on securities related to subprime mortgages. Barclays Capital estimates losses may increase by $200 billion.
Subprime-related losses also hit bond insurance companies that guarantee about half of all U.S. municipal debt, weakening investors’ confidence in the AAA corporate ratings that are applied to the obligations and hurting prices last month.
Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That’s the worst performance since 1999, when state and local government debt lost 6.34 percent…
…Municipal yields rose to the highest compared with Treasuries since 2003, data compiled by Bloomberg show.
Yields on 10-year municipal bonds averaged about 93 percent of what the U.S. government pays, compared with 83 percent on average in the two years before August. Investors typically accept lower rates on state and local debt because interest is exempt from taxes…’
Losses in subprime lending have had an effect on public finance that few would have foreseen. As a result of the selling pressure, yields on muni bonds now approach those of taxable Treasury bonds. When this has happened in the past, it represented a buying opportunity.
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Considering that most people who buy Munis adopt a buy and hold strategy, the bad year for muni’s sounds like good news. When you can reinvest dividends and put new money to work at lower prices and higher yields that seems to be a good thing.
Excellent point Joe. As I mentioned in the last paragraph, bad years have been buying opportunities in the past.
“bond insurance companies that guarantee about half of all U.S. municipal debt”
What happens to the value of those Munis if the bond insurers go belly up? Look at charts for MBI, ABK & ACAH to see what the market is saying about them (and that’s after MBI got a $1 billion cash infusion recently.) Just the inevitable debt downgrades for the insurers will send Munis in a tailspin. It’s too ugly to think about what the collapse of one of the big insurers will do (which is a real possibility)…
Penelope — As this post indicates, it has been a tough year for munis. I think the muni market has already priced in serious problems with ratings.
“the muni market has already priced in serious problems with ratings”
Did the financial stocks have the bad news “already priced in” when Bill Miller bought all those stocks? Or how about the homebuilders before it was completely obvious there was a bubble?
Lots of folks can’t see the writing on the wall until they read about it in the morning paper. Munis will be no different (plus there’s the additional issue of poor liquidity that will also weigh on prices).
Not sure what Bill Miller has to do with muni bonds Penelope. Problems with municipal bond insurers stem, not from their muni bond insurance products, but from other insurance products they offer, for example insurance on mortgage securities. It’s unlikely that MBIA would fail, but if it did, I do not think it will result in big problems for munis, except for a short-term blip.
There are some interesting articles regarding munis in the Wall St. Journal (12/22) and Barron’s (12/24) that support your argument. It’ll be entertaining to watch how it all unfolds.