A Bloomberg story reveals that municipal bonds have lagged other fixed income investments, mainly because important investors, namely hedge funds and banks, are directing capital to other uses (as in saving their hides). Due to their tax-deductible status, munis trade at a lower yield than Treasuries, but that differential has narrowed markedly.
Are munis a buy? We don’t give investment advice, and it’s a tough call. On the one hand, the fundamental outlook isn’t pretty, since municipalities in particular depend on real-estate related income, which is under pressure and likely to get worse before it gets better. There is also the overhang of the risk of a downgrade of a municipal bond insurer, which is likely to have more price impact than fundamental impact. Funds that hold munis only of certain ratings will sell, leading to price pressure.
But the dirty secret of municipal bond insurance was that it was very close to free money. States and municipalities, even when they get in trouble, very rarely do worse than miss a payment or two (the Washington Public Power Supply System was a notable exception, but also wasn’t guaranteed by insurers either) and the guarantors were thus collecting handsome fees for almost no risk assumptions. So the doubts about the ability to pay of bond insurers doesn’t have as large a fundamental impact on munis as one might expect.
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 at the fastest pace in at least 12 years during the third quarter, 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.”
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.
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
As investors retreated from corporate and asset-backed bonds to the safety of Treasuries, some also sold munis as losses on mortgages made to people with poor credit began to spread in August. 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.
Borrowing costs are also rising in part because the housing market is enduring its deepest slump in 16 years. Falling property values may slash tax revenue for states and cities by more than $6.6 billion in 2008, according to a November report by the U.S. Conference of Mayors.
“Reduced demand from some traders may keep municipal yields higher than they ought to be for an extended time,” said James Kochan, fixed-income strategist at Wells Fargo & Co.’s Funds Management Group, which oversees $3.2 billion of municipal bonds. “Eventually, buyers will emerge and we will see this was a major opportunity.”
That’s the opposite of what happened a year ago, when firms such as New York-based Citigroup, the biggest U.S. bank, along with hedge funds piled into munis, Fed data show.
“The market became more reliant on trading accounts and arbitragers, and now it faces a greater risk of capital being pulled from those kind of buyers,” Kochan said…..
Municipal bond hedge funds, which helped fueled the market gains, have also reduced their investments, Eaton Vance’s Metzold said. Municipal hedge fund losses through early November ranged from 5 percent to 30 percent, according to Evan Ratnow, an analyst at Fortigent, a Rockville, Maryland-based consultant who monitors municipal hedge funds on behalf of investment advisers who control $18 billion of assets.
“The funds are seeking new accounts, but their recent performance was a lot worse than some people thought possible,” Ratnow said. “On the positive side, the funds have a history of producing big gains after months with big losses.”