Muni Carnage

I have been involved, one way or another, with the municipal market for four decades, and in that time I cannot recall carnage such as we have seen the past two weeks. Two weeks ago, the yield on the Bloomberg 10-year AAA GO benchmark was 0.80%. On Friday that yield was 2.88%. That translates into a price drop of almost 20 points. For 30-year GO bonds, the price decline is almost twice as great. And for many troubled revenue names, getting any bid has become difficult or impossible. For comparison, over the same period, the yield on the 10-year Treasury rose approximately 30 bps. The price declines on the top-quality munis have been as great as those on high yield corporate bonds.

There have been other periods of market meltdowns, but not like this in munis. In early February 1980, (remember Jimmy Carter?)the corporate bond market stopped trading and Treasury bond bid/offer spreads widened to as much as a point. In 2008, high yield corporate spreads reached 2000 bps (they are around 1000 bps now)and some short-term markets seized up. But even in those bad markets, munis tended to perform better than taxables. In the past two weeks they have performed much worse than comparable taxables.

Two factors appear to be responsible for this carnage. Fears of a prolonged, deep recession that would decimate revenues to state and local governments is one. But more important, in my view, is that portfolio managers had been posting such good returns these past two years, that they were more than fully invested, unprepared for even a modest selloff. Then, when they needed to raise cash to meet withdrawals, they confronted a market in which dealers are far less equipped to make good bids than they were before Dodd-Frank. A version of a perfect storm.

Even the Treasury market succumbed to this storm. There too, almost every participant was long, the shorts having been squeezed out in the prior weeks. Thus, when the prospect of a huge increase in Treasury borrowing prompted some selling, there were no natural buyers. And when equities get hit badly, high yield corporate spreads always widen significantly. So the current disarray in that market is not surprising.

So, what are we to do? At yields close to 3%, the 10-year AAA munis are priced as if the 10-year Treasury yield were above 3%. We are unlikely to see that Treasury yield anytime soon–perhaps not for a year or more. The Fed is going to keep the funds rate near zero well after the economy has begun to recover from this recession. At the risk of grabbing a falling knife, I would be buying munis at these yield levels. Better yet, buy a fund that is supported by a seasoned team of credit analysts. It is often a good idea to avoid stepping into a high yield market in disarray. This, however, is a market of solid credits now dominated by irrational selling. As Mr. Buffett is fond of saying, buy when there is blood in the streets. That is an apt description of the muni market today.

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