In response to the blizzard of e-mails and phone calls asking the question, “What’s up with my market values?” we will attempt a simple explanation of the “perfect storm” currently buffeting the municipal bond market.
The good old days
If you are like most municipal bond investors, 2008 began quite uneventfully. You sat back and watched the craziness occurring in the stock and commodities markets, feeling ever so comfortable and grateful that you owned stodgy, conservative municipal bonds, which were providing a steady, dependable stream of tax-free income and very little unwanted excitement.
Shortly thereafter, stories began surfacing about securities that contained something called “sub-prime mortgages” (collateralized debt obligations or CDOs) and, once again, you were grateful you didn’t invest in any of those things, whatever they were.
A painful realization
You were then confronted with the realization that the same companies that insured your municipal bonds were also guaranteeing these CDOs, and major Wall Street banks and brokerage firms, such as Citigroup and Merrill Lynch, were taking massive writedowns because of these same previously obscure securities.
When the rating agencies began to threaten the “AAA” insurers with downgrades, the credit crisis finally began to impact the municipal bond market.
“Tender option funds,” fearing this downgrade of the insurers, began to liquidate their substantial holdings of municipal bonds.
The same dynamic occurred more recently in the auction rate securities market (floaters), as auctions began to fail at major brokerages and in closed-end mutual funds.
These floaters were typically considered short-term instruments because investors could withdraw their money through regular auctions on a short-term basis. Unfortunately, these auctions are based around long-term municipal bonds, which are now being liquidated, further glutting the market with supply.
As you can see, the major banks, brokerages and hedge funds that traditionally provided support to the municipal bond market are now forced to be net sellers of bonds to enhance their own liquidity.
Finally, due to the illiquidity in the marketplace, matrix pricing systems, utilized by all brokerage firms for month-end statements, are struggling to assign values to bond holdings, further alarming investors.
The bottom line is the municipal bond market is thinner and more volatile today than any time in recent memory.
The opportunity
Here’s the good news: Municipal bonds, fundamentally, continue to perform well, paying principal and interest on time, without the help of the beleaguered bond insurers. The fact that municipal bonds are providing higher yields today in comparison to their taxable brethren should be viewed as an unusual buying opportunity for municipal investors.
We can’t recall a period when municipal bonds could be purchased to yield one full percent (100 basis points) more than taxable Treasury bonds.
Sometime down the road, as with all financial disruptions, this too shall pass. Institutional selling will subside and municipal bonds will return to a more normal relationship with taxable fixed income investments.
Remember, you don’t buy bonds for capital gains, you buy them for the tax-free income.
Stay the course
Municipal bonds as an asset class continue to pay principal and interest on time. Don’t worry about your market values. As the crisis fades, prices will stabilize and you will be pleased you took advantage of the opportunities available today.
