Bubble trouble for muni bonds?

December 17, 2010, 5:05 PM UTC

Muni bonds don’t exactly turn heads when times are good. But lately they are getting a lot more attention than their embattled fans would like.

After rising through the first 10 months of 2010, the average municipal bond fund has lost 3% in just the past month, according to TrimTabs. Some funds have lost 10% or more this fall, as the long bull market in Treasury debt has come up lame and worries about stretched state and local government budgets have started getting more attention.

Not getting any easier

Muni funds have suffered outflows in five straight weeks, with $9.3 billion in investor funds taking flight. Managers who had been rolling in new money are now struggling with “a huge shot of redemptions,” says Alex Grant, manager of the $300 million RS Tax-Exempt fund.

Worse yet, he says each new report of outflows brings out more sellers, adding to the sense of building panic. “There is a ton of headline risk out there right now,” he said.

Yet Grant and his ilk insist predictions of widespread defaults and comparisons to the subprime mortgage market are wrong-headed if not downright gratuitous.

No one denies municipalities have huge problems ahead in dealing with underfunded pensions and costly healthcare obligations, and that investors must be diligent and choosy. There is no denying that Harrisburg, Pa., defaulted, and that Vallejo, Calif., is in bankruptcy, and there will be more such messy endings.

But backers say defaults will continue to be rare and that come January, when the new issue calendar clears and we get another update on the economy, the long-term investors who drive most muni volume will soon be kicking themselves if they aren’t buying.

“We have an onslaught of supply ahead of the expiration of the Build America Bonds program, and a lot of over-the-top worries about the health of the municipal sector,” says Mark Vitner, a senior economist at Wells Fargo. “You hear people talking about the muni market becoming another domino to fall, but I have to say that’s not something I lose a lot of sleep over.”

The skittishness about bonds comes as municipalities have been lining up to sell new debt ahead of the year-end expiration of the Build America Bond program.

That program, enacted in 2009 as part of the first Obama stimulus program, subsidized taxable bond issuance in a bid to reopen the market for long-duration bonds to qualified municipal issuers.

Until recently it was widely assumed that the Build America program would be extended. But the BAB extension was left out of the tax deal announced last week, and selling in the muni markets have increased amid questions about how high muni yields might have to rise to satisfy additional demand.

Build America issuance has accounted for about a quarter of the $389 billion of muni bond sales so far this year. Assuming the program isn’t extended, the supply of tax-exempt muni bonds will expand by about that much, which naturally will drive down prices.

Some of that has already happened. The yield on 10-year triple-A munis has risen to an 18-month high above 3%, while that on 30-year bonds has soared near 5%.

Among those hardest hit have been funds such as Nuveen Premium Income Municipal Fund 2, which holds 93% of its assets in tax-free muni bonds from states including California, Illinois and Florida. It has dropped 12% this fall and now trades at a 6% discount to its asset value.

Even so, the demise of the Build America program may not present a serious threat to the muni market’s health. An estimate published by the Securities Industry Financial Market Association trade group says muni issuance could hit $500 billion next year. The average over the past decade is around $380 billion.

But Vitner says he believes there may be less issuance in coming years as cash-strapped municipalities put new projects on hold in recognition of a long stretch of slower growth ahead.

Though Build America’s demise has been treated in some quarters as a shock, Vitner sees it as a rare instance in which Washington is actually, intentionally or not, on course to carry out its exit strategy.

“That program has more or less served its purpose,” Vitner said.

And while there will be more defaults, those predicting massive muni defaults are likely to be disappointed. Municipalities, after all, need the money – so they need to retain their access to the bond market. There will be some scares, yes, but few actual failures to pay.

“If I hear about Harrisburg one more time, I’m going to throw myself out the window,” says Grant.