The state of Illinois’s recent settlement with the SEC for “misguiding” investors about its underfunded pension obligations, has brought municipal bonds back into the spotlight.
Fraud is as old a risk as any, but there are now other concerns about muni bonds, some old, some new.
False Assumptions about Muni Defaults
Is the default rate of muni bonds 0.6% or not? Well, it depends on who you ask.
If you ask the ratings agencies, they would agree with the 0.6% historical muni bond default rate. Their data suggests that only 47 municipalities defaulted between the years 1986 to 2011. But this number is based solely on those bonds the ratings agencies actually rate.
We also should keep in mind these are the same ratings agencies now being sued for “misleading” what they really knew about the housing market in 2006. Is it also possible some of the highly rated municipal bonds are actually riskier than their ratings imply? You betcha.
What the Fed Said
If you ask the Federal
Reserve, they suggest the default rate is much higher. Their 2012 report shows 2,366 defaults in the
same period. This amount of defaults is only 50x more than the ratings agencies
imply. To be fair, their sample size is
also a lot larger making the actual default rate assumption from the Fed more around
4%. But even so, the Fed's data shows a 7x higher versus historical data published by the ratings agencies.
In an article titled, "Municipal Bond Defaults are Higher than Reported," we highlighted some of these very points. Why should we still care?
Because, as we outlined in the ETF Profit Strategy Newsletter released 7/20/12 when MUB was trading at $110, “Conservative investors should avoid the munibond sector. For aggressive traders, a shorting opportunity will come, but only after the market technicals first confirm that it’s time to do so”. By the way, the MUB is still trading around that $110 price, and now the charts may be aligning with the negative fundamental outlook.
What the Charts are Saying
Over the longer-term, municipal bond rates remain near 50 year lows as the Federal Reserve chart shows. But this may be changing as cracks are starting to form in the foundation of the shorter-term.
In our ETF Technical Forecast provided 3/10/13 we stated, “Keep an eye on the (NYSEARCA:MUB) and (NYSEARCA:HYD) indices as we have been talking about the coming disaster in muni bonds for awhile now, and these charts may be the first signs of a longer-term change in trend for munis. A breakdown of MUB may put that trade on the map.” In the chart below the iShares S&P National Municipal Bond Fund is shown over the past 5 years and shows the recent weakness in MUB.
We also provided a short-term trade with a Reward:Risk ratio of over 3:1 for HYD.
The first thing to notice is the previous declines of the index have not encroached into the price territory of the previous peaks. In 2008 muni bonds sold off from the $87.5 level and then recovered making a new high at $99. The ensuing pullback then held above $87.5 into 2011. The next decline occurred at the beginning of 2012. This pullback too did not reach the previous peak at $99.
The latest pullback, though, has now breached that $110 previous peak. This is coupled with declining momentum shown in the bottom section. None of the previous peaks were associated with such loss of momentum and this is a warning.
The fundamental risks have been in place for awhile, now we are just waiting for the technicals to confirm the top, which may indeed be occurring now.The latest issue of the ETF Technical Forecast includes a focus on Municipal Bonds and price levels that can be used to short, place stops, and target for profits. We use fundamental, technical, and sentiment data along with common sense to provide a unique perspective that goes beyond traditional investment strategies.