Opinion

Felix Salmon

Institutions exit the muni market

By Felix Salmon
July 8, 2010

Jenn Ablan takes a look at the muni market today, and although inflows have been strong this year, the smart money seems to be moving out of the market, positioning itself for a gruesome second half of the year.

The muni market is a curious beast. Most of it is highly illiquid, with small issuers, buy-and-hold retail investors, and tax-exemption rules which make enormous differences to the value of securities depending on where you live and what your tax rate is. At the same time, some big institutional players like to rotate in and out of the market on a speculative basis, with short time horizons, and when they do, they’re big enough to act as marginal price setters. If they’re moving on to the next thing, then prices are likely to fall a little — which is actually no big deal, for anybody but institutional investors who mark to market. Municipalities will pay a little more to borrow, but rates are still extremely low, and their investors, who are also their voters, will get slightly more attractive rates on their money.

The big danger in most markets when institutional investors leave it for dead is that it closes up entirely, and that borrowers have no market access at any price. That’s less of a worry when it comes to munis because they’re mainly reliant on individuals. At some point, if there’s lots of talk of default, then retail investors might stop buying municipal bonds, but that’s a little bit down the road. First you get the price decline (and CDS spreads widening out further still), then you get the default talk, and only then do you get the retail well drying up.

For institutions who mark to market, then, it makes sense to avoid munis for the time being: they have more downside than upside. But for buy-and-hold individuals, there’s no real reason to panic: you’re going to hold your bonds to maturity anyway, so it doesn’t really matter what happens to their value in the interim. And the chances are that they’re not going to default; what’s more, even if they do, you’ll probably end up getting your money back eventually in any case. And if you’ve lent to a big state-level borrower like California or New York or Illinois, you can be pretty sure that there will be some kind of government bailout too.

The real worry here is with the monoline insurers: municipalities are more likely to default if they know that their voters are still going to receive their coupon payments from an insurance company which provided a wrap for their bonds. But for the time being, at least, I’m not worried about a complete collapse of the muni market, where local governments in need of funds can’t raise the money at any price. That could yet happen, but I doubt it’s going to happen this year.

Comments
4 comments so far | RSS Comments RSS

One possibility is that the muni market will split into ‘safe’ and ‘unsafe’ sub-markets. If I held California or Illinois bonds, I’d be feeling itchy– but for states not on the default precipice, not so much. As you say, prices will go up and down, but if the default risk is low, it doesn’t really matter very much.

Posted by MattF | Report as abusive
 

How many munis have EVER defaulted? Could probably count them on the fingers of one hand. That being said, dumping munis across the board is self-defeating; the idea of due diligence should open up great opportunities for investors if institutions wanna dump everything

Posted by CDNrebel | Report as abusive
 

Your point about the monolines is correct up to a point. I have no idea what that point is, but I suspect Warren Buffet does. He bailed on the monoline business. Anyone who sleeps better at night because he’s insured by a monoline sure isn’t Warren Buffet. Which means he probably shouldn’t be in munis.

Posted by maynardGkeynes | Report as abusive
 

CNDRebel? What about the ARS securities they issued that the banks were forced to buy back? I also recollect the mortgage market was the same only a couple of yeahs ago.

Finally, shouldn’t these buysides being doing due diligence anyway? Crazy, outrageous idea I know. After all if they lose money they can just blame it on Goldmans.

Posted by Danny_Black | Report as abusive
 

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