There’s a short WSJ article entitled Credit Crunch Provides Opening In Muni Bonds about yields rising (prices dropping) on muni bonds. What are the reasons for the price shift?
The first is that investors have been selling anything not issued directly by the federal government — irrespective of the issuer’s credit-worthiness. That has included an aversion to debt issued by state and local governments.
Second, the municipal-bond market has been rattled by concerns about the financial health of companies that insure bond issuers against defaulting on their interest payments.
These insurers also guaranteed bonds backed by low-quality mortgages and are under pressure to back up those guarantees or face ratings downgrades.
That last paragraph about the private bond insurers not being strong enough to repay on default echoes David Einhorn’s take on municipal bond (under)ratings and bond insurance:
The misrating of municipal bonds directly benefits the friends of the ratings agencies on Wall Street, the banks who underwrite the deals. A lower rating - means bigger underwriting fees. Or alternatively, the excess cost can be shared with another great friend - I mean very large customer - of the rating agencies - the municipal bond insurers who effectively rebate some of the “overcharge” to the municipalities in exchange for a share of the savings through a scheme called “bond insurance.” The municipalities purchase bond insurance to enhance their credits to AAA level. Of course, since they are in fact, AAA to begin with, the insurance provides no true benefit.
I assure you that a quick peak at the balance sheets of any of these so-called AAA rated bond insurers will tell you that they are not likely to be there to pay more than a fraction of the claims they have insured in an environment where there are wide-scale defaults in the municipal bond sector.
So, what to do? Do you invest in munis even though you realize that the bond insurance is junk …. because you also know that the bond insurance wasn’t originally needed anyway … since the munis were underrated by the agencies?
The big question is will they actually default? The Journal reiterates the view of Einhorn, noting “that just 0.1% [of investment grade muni bonds] failed to make good on interest payments — a far lower rate than on corporate bonds.” From my joe-citizen perspective, I’d also agree that default seems unlikely. Municipalities probably won’t become fiscally sustainable anytime soon … but, like most Americans, municipalities should be resourceful enough to find money to pay off their ever-mounting interest (at least for awhile). Municipalities can raise taxes, sell off the local park, sell rights to run government services as legalized monopolies, or just ask the state/federal government for a bailout. And that last option just means printing money, so I’d expect inflation before any of these municipalities really default.
But still, playing the markets is all about the timing your investments: if when the bond insurers get more bad press from their financial instability, muni bond prices could will drop even further and be an even better deal. So all you have to do is time the market. Easy.