Saturday, January 22, 2011

Getting Around Municipal Bond Default Risks

By now, many in the US have either seen or heard the latest municipal default risk opinion by Meredith Whitney which was broadly distributed by that venerated news program "60 Minutes" in December, 2010. At the conclusion of the program, many bond investors picked up both their babies and their bath water and dutifully hauled both out to the curb without even a second thought.

Along with weak credits such as Harrisburg PA, stronger credits have suffered. In fact, the very strongest type of municipal bond credit in the country ended up on the curb, right next to its lesser counterparts. Escrowed to maturity municipal bonds and pre-refunded municipal bonds have suffered the same fate as Harrisburg PA bonds.

When an individual borrows high and sees rates drop, such as with a mortgage, the individual can go and borrow at a new lower rate and pay off the higher rate mortgage with the newly borrowed money. Municipalities do much the same. High interest rate debt from years ago can be refinanced with money borrowed at lower rates. The older municipal bonds that get paid off are escrowed to maturity or pre refunded...often by US Treasuries...which are held in an escrow account and are used to pay the principal and interest of the old bonds. In effect, the holder of an escrowed or pre refunded bond has a tax exempt municipal bond backed by US Treasuries paying tax exempt interest.

Along with names such as Harrisburg PA, various escrowed and pre refunded bonds have similarly gotten cast aside by investors rushing for the exit doors in order to avoid municipal defaults. Currently, many escrowed and pre refunded munis are trading cheaper than Treasuries. That's right- cheaper - than Treasuries, which has happened only a handful of times since the mid 1980s.

Municipal bond investors have been leaving municipal bond funds for over 2 months. We have had 9 or 10 weeks of steady outflows from municipal bond funds to the tune of some $25 billion. The muni bond fund managers of the largest fund companies in the world wake up, come to work, and begin putting bonds out for the bid to satisfy investor withdrawals.

There are always opportunities in the midst of panic, and right now, one of the highest quality municipal bonds in the country is being treated like a lowly incinerator bond. Want safe, tax exempt income? It's right out there on the curb....



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