Are Municipal Bonds a Ticking Time Bomb?
By Ron DeLegge
December 13, 2010
SAN DIEGO (ETFguide.com) – If there’s one great thing you could say about low interest rates it’s that they’ve given a lot of over indebted states time to get their financial house in order. That’s the good news. The bad news is that states, even with the help of rock bottom borrowing rates, are still spiraling.
Is the municipal bond market a ticking time bomb? Let's analyze the situation.
Wall Street’s Three Musketeers
The failings of today’s U.S. credit rating regime, a monopoly of three musketeers, are no secret. A lack of foresight by Fitch Ratings, Moody’s and Standard & Poor’s along with pressure from Wall Street’s aggressive underwriters to assign high ratings to unworthy debt led to billions of dollars in mis-rated mortgage bonds during the 2008-09 financial crisis.
These massive conflicts of interest that contributed in part to the crisis continue to plague the entire bond market, including the way municipal bonds are rated.
In April, California’s $68 billion of general obligation bonds were moved up from BBB to A-minus by Fitch Ratings despite the fact the state’s fiscal situation is worsening. Granted, A-minus is still the lowest credit rating among 50 states but does it really accurately reflect the danger of lending money to a fiscally challenged state like California?
Fitch used the occasion to explain that California’s credit rating wasn’t really upgraded but rather a series of “adjustments to denote a comparable level of credit risk as ratings in other sectors.”
Maybe it’s asking too much but any “adjustments” or “improvements” in the way credit ratings are assigned shouldn’t result in a favorable score for questionable borrowers. Simply put, credit ratings have followed the same general path as boat building: Amateurs built the Ark but experts built the Titanic.
New Animal: The Tie-Dyed Swan
Nicholas Taleb, a hedge fund manager, popularized the Black Swan Theory in his attempt to explain the existence of unforeseen and unpredictable high impact events. However, classifying future municipal bond defaults as “Black Swans” is probably a stretch. While such occurrences have been rare historically speaking, they aren’t entirely an unknown occurrence which would make them something else.
As such, a new animal, the “Tie-Dyed Swan” might be the best description of today’s munibond market.
A person could safely argue the flat year-to-date returns for heavily indebted states like California (NYSEArca: CXA) and New York (NYSEArca: INY) are hardly reflective of their underlying fiscal crisis. Complacent munibond investors this time around may be taken surprise by swans with changing colors. (Please don’t mistake these particular swans for the multi-colored peacock used by a certain financial network.) While the tax benefits of owning munibonds have been thoroughly extolled, their true credit risk hasn’t.
How far will the crisis of overleveraged states go? And will it spill over into other credit markets? What kind of financial risk is mis-rated munibond debt causing? And will this turn out to be the federal government’s next bailout?
In July when munibonds (NYSEArca: MUB) were still on a roll and most credit analysts believed the worst was over, ETFguide’s ETF newsletter warned: "The state of California's $20 billion budget shortfall sets the gold standard of what's become fiscal perversion among state and local government everywhere. The only other place with more financial incompetence per square foot is Washington D.C. Tax revenues are drastically own, yet expenses keep rising at an astonishing pace.” Beyond that, it covered profit opportunities and strategies for capital protection in the face of the coming hurricane. Are you ready?