Muni bond market: what happened since Meredith Whitney’s December 19, 2010 Report?Gaetan Lion, April 11, 2012.

Somehow, public finances did not collapse as much as she suggested. We can capture the health of the Muni bond markets through several indicators, including: 1) the price of Credit Default Swaps on Munis; 2) the price of one of the largest ETF Muni Bond fund (MUB); 3) the yield on Munis; and 4) Muni default rates. The dotted vertical lines on those graphs reflect the time Meredith Whitney (MW) released her report.

First, let’s look at Credit Default Swaps…

Next, let’s look at the price of the ETF Muni Bond fund (MUB).

Price of IShares S&P National Muni Bd. Fd (MUB)

85

90

95

100

105

110

115

9/14/2007

12/14/2007

3/14/2008

6/14/2008

9/14/2008

12/14/2008

3/14/2009

6/14/2009

9/14/2009

12/14/2009

3/14/2010

6/14/2010

9/14/2010

12/14/2010

3/14/2011

6/14/2011

9/14/2011

12/14/2011

3/14/2012

Let’s look at yields or interest rates on Munis.

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MW report essentially captured the peak of the perceived credit risk in Munis through high CDS prices at the end of 2010. Ever since CDS prices have dropped suggesting a marked decrease in Munis credit risk for those 5 large States. Unfortunately we lack more current data.

When price of the MUB go up it suggests positive trends in terms of decreasing credit risk, declining related yield, etc… Again, MW report caught the bottom of the trend as the price of the MUB bottomed out and rapidly rose thereafter.

Yield on 20 year Munis

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

2006-01

2006-04

2006-07

2006-10

2007-01

2007-04

2007-07

2007-10

2008-01

2008-04

2008-07

2008-10

2009-01

2009-04

2009-07

2009-10

2010-01

2010-04

2010-07

2010-10

2011-01

2011-04

2011-07

2011-10

2012-01

As noted the first three Muni bond market signals suggest Meredith Whitney was plain wrong and investors would have profited from doing the opposite of her recommendation. But, the situation gets muddled when we look at Muni bond default rate next…

Sources: Distressed Debt Securities Newsletter and Putnam Investments.

Muni Defaults as a % of outstandings

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

1990199119921993199419951996199719981999200020012002200320042005200620072008200920102011

Muni default rates more than tripled after Meredith Whitney’s report suggesting that her call was correct. Yet, keep in mind such default rates are still low. Munis default rates at all equivalent bond ratings are far lower than corporate bond default rates. And, recoveries after default are a lot higher than for corporate bonds (65% vs 49% Epoch time article 4/05/2012). Thus, Meredith Whitney was directionally correct. But, her call was too Cassandra like as she projected a level of $ default that was much higher than what ultimately occurred.

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Again MW report catches the trend near the top as Munis yields peak shortly after her report comes out. We could also have looked at spreads between Munis and AAA rated corporate bonds or 10 year Treasuries. But, those spread indicators were trendless and not informative.

How did the Muni bond market avoid the apocalypse foreseen by Meredith Whitney?In January 2011, Vanguard issued a rebutting report called “California is not Greece” just a couple of weeks after Meredith Whitney. Vanguard conveyed that the Muni bond market was more resilient due to structural factors that MW ignored such as:

The vast majority of Munis have long term maturities associated with self-amortizing debt service of over 20 years. Thus, refinancing risk is low and gives public entities time to get their fiscal affairs in order.

State-level debt burden is modest as a % of gross state product, averaging less than 2.8% nationwide with Massachusetts being the most indebted State with a ratio of only 8.3% (around the same time the US ratio was close to 70% and Greece probably over 200%).

Given the States’ low debt ratio, bond default represents a negative trade off including being shut out of the capital markets. Yet States do need financing.

Individual investors (directly or through bond funds) hold nearly 70% of Munis. For a State or a municipality to default and hurt its own taxpayers and voters is not a good idea. By the same token, individual investors being the major Muni bond investors reduce the systemic risk of Muni bonds.

Is all well in the Muni bond market?No, it is not. The same Vanguard report mentioned the Pension crisis citing that pension and retirement health care plans were grossly underfunded to the tune of $1 trillion. The financial crisis aftermath including depressed housing prices did hurt local government revenues through declining sales and property tax receipts. Yet, social transfer payments have increased local government expenditures.

Municipal bond defaults, although rare, are at a record high since 1990 as shown earlier. Several California cities and municipalities are struggling to meet their pension obligation and debt service requirements including Stockton, Vallejo, San Jose, and Hercules. Other municipalities in other States are also struggling for the same reasons.

Detroit is in near fiscal limbo. The future of its local governance is highly uncertain as it may be affected by Michigan’s Financial Emergency Law whereby when a local government is unable to shore up its fiscal situation, the State appoints a team of Financial Emergency Managers that take over. The rest of the States are watching Michigan’s law to see how effective it is and how related constitutional and political challenges develop.

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