Fears of a massive wave of municipal bond defaults have given rise to a new question: how can investors profit if a nightmare meltdown scenario becomes reality?
Photo by: John Carney
The once boring muni bond market has become a hotbed of controversy. Huge public pension liabilities, declining tax revenues, and ballooning budget deficits have created financial challenges for states, cities and towns across America.
Meredith Whitney has famously announced that many muni-bonds are too risky for the meager returns they offer. Jim Chanos backed her up on "Squawk Box" today, arguing that many states are basically insolvent. Others, including some prominent muni-bond experts, have said that these fears are over-stated.
Investors are dividing on the question. Many hedge funds have started looking for bargains in muni bonds, searching for debt that might have been beaten down too far. Some are betting that the federal government will step in to rescue the muni debt market if the stress becomes too extreme.
Hard To Short
There has long been an imbalance in the market. It’s far easier to take a bullish position in muni debt than to take a bearish position. Bullish investors can directly buy muni bonds through brokers, or invest in an almost unlimited number of muni bond funds. Bearish investors cannot easily short muni bonds the way they could, say, short an overpriced stock. Most of the bonds cannot be borrowed—the first step in an ordinary short trade—because they are owned by individuals or mutual funds that don’t hold them in trading accounts.
This imbalance implies that the pricing in the muni bond market might not reflect the full array of perspectives. At least in theory, this could lead to risk in the muni market being underpriced—and the bonds, therefore, overpriced. And because many of the buyers of muni bonds are “buy and hold” types, the mispricing of this risk could remain invisible for an extended period. What’s more, the disappearance of bond insurance has made pricing even more opaque. Combined, these factors could create a unique investment opportunity for muni bond bears.
Since the bonds cannot be shorted directly, it might be tempting to short them indirectly by buying credit default swaps that would pay off if the bonds default. Unfortunately, this is almost as difficult as the short sales.
Historically, it was possible to buy credit protection on some muni bonds. But all but one of the bond insurers has ceased doing new business. And most credit protection on munis was sold as wraps around the original issuance and is impossible to buy without also buying the bond itself. The few sellers of “naked” muni bond insurance tend to be savvy fund managers who are very careful about the debt they are insuring against, which means that using swaps to short the riskiest muni debt is very expensive if not impossible.
So Short The Insurers
One relatively straight-forward way to take a bearish position on the muni market is to short the big muni bond insurers. The financial crisis, however, totally reshaped this market and the companies that participate in it. Traditionally, around 45 percent to 60 percent of muni debt issued was insured.
That business was more or less destroyed when many of the big insurers fell into financial distress due to insurance they had offered on mortgage-linked investments. These days only between 5 percent and 10 percent of new muni debt is covered by insurance. The stock prices of these companies have suffered heavily. Assured Guaranty Municipal Co. is the last of big players in muni bond insurance still writing new insurance.
Nonetheless, the big bond insurers have a huge backlog of outstanding insured debt. In an event of default, these insurers are typically obligated to make interest and principal payments in the place of the debt issuer. If the volume of defaults are much higher than expected, these insurers may find themselves in financial distress once again.
The world's largest insurer of municipal bonds was the Municipal Bond Insurance Association. It is attempting a restructuring that would split the company, dividing the troubled mortgage and derivatives insurance business from the municipal insurance business, but that is being challenged in at least two courts. Another large municipal bond insurers is the American Municipal Bond Assurance Corporation , which is now in bankruptcy. Radian Asset Assurance has a sizable legacy business as well.
With these companies so beaten down over the past years, however, shorting them might be a risky bet. A lot of the bearish case against them is likely already priced in. The same goes for the bonds issued by these companies, many of which have seen the cost of swaps on their debt skyrocket.
Or Short The Muni Bond ETFs
If shorting the insurers seems too risky, another tactic is shorting the muni bond exchange traded funds. The largest muni ETF is iShares S&P National Municipal Bond Fund . It is meant to track the S&P National AMT-Free Municipal Bond Index, which measures the performance of the investment grade segment of the muni market. MUB is allocated over 1,000 different issues, which means that it is a barometer of the overall health of the market. It also makes it unlikely it would be heavily impacted by defaults in any one region. But if you think we might see a widespread meltdown in the muni bond market, shorting this ETF would create the desired exposure. It has fallen 6 percent in the last six months.
The states that are widely viewed as facing the most serious budget crises are California, New York, New Jersey and Illinois. You can short ETFs for each of these states.
Alternatively, the Market Vectors High-Yield Muni ETF invests in bonds with below investment-grade ratings. This could be ground zero for an outbreak of muni defections. It is becoming a hot spot for investors on either side of the trade to take positions on the possibility of a default wave.
There’s one way to make a hybrid bet against both muni bonds and the insurers. That’s to short the PowerShares Insured National Municipal Bond Portfolio (PZA). This ETF is based on BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index. It is designed to track the performance of U.S. dollar-denominated, investment-grade, insured muni debt. This debt looks relatively safe. But if you think that defaults are coming and the insurance will be worthless, it’s reasonable to conclude that the assets held by PZA are overvalued.
None of this is for the faint-hearted. Shorting muni bonds is not only difficult, it is risky. Beyond the risk that the basic thesis that states and local governments will not be able to afford their debt could be wrong, bears are running the risk that the federal government could step in to bail out the states.
But if your inner bear growls when you think about state and local financing, you might want to start looking for tactics such as these. There’s no reason why a collapse of muni finance needs to hurt your investment portfolio.
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