Muni Land Contrarians

Meredith Whitney on Closing Bell
Meredith Whitney on Closing Bell

With all the gloom surrounding municipal finance some investors are still taking the opposite side of the trade.

According to a recent Bloomberg article:

"Tom Kozlik, a municipal bond analyst for Philadelphia brokerage Janney Montgomery Scott, sent clients a note on Jan. 14 reminding them of Warren Buffett's advice for navigating market turmoil: Be greedy when others are fearful."

Of course, that fear follows close upon the heels of Meredith Whitney's warning of untold billions in defaults in the municipal bond market.

That market is enormous as the Bloomberg article points out: There are $2.9 trillion in U.S. state and local government bond debt currently outstanding.

A market of that size—especially one that undergirds critical functions such as essential government services—is bound to draw attention when the figures look shaky. With aggregate state budget deficits of $140 billion, that is exactly what is happening. And the impact is being felt in the marketplace.

Again, according to Bloomberg:

"Investors pulled money from mutual funds that buy municipal securities for nine straight weeks through Jan. 12. Those withdrawals helped drive returns on muni bonds down 4.5 percent during the final three months of 2010, the worst quarterly return since the beginning of 1994, according to Bank of America Merrill Lynch's index. This year the slide is continuing. The average muni yield, which moves in the opposite direction of price, jumped to 5.39 percent last week, the highest since the depths of the financial crisis in December 2008. When the New Jersey Economic Development Authority tapped the market on Jan. 13, the size of the deal was cut back by nearly half the original offer because of the high interest rates muni investors were demanding. That same day, Governor Chris Christie warned that health-care costs for workers threatened to 'bankrupt' the state."

The contrarian case is perhaps best exemplified by Bill Gross, who manages PIMCO's Total Return Fund—the world's largest mutual fund.

Gross is still a buyer. He was recently quoted saying "The overwhelming preponderance of local governments respond by cutting spending or raising other revenues, not by defaulting on debt," Adding: "The bottom line is that sky-is-falling reports about the muni market are lacking in evidence."

Bloomberg makes the quantitative case:

"There are some signs that municipal finances are beginning to mend. State and local government tax revenue rose 5.2 percent during the third quarter, according to the U.S. Census Bureau, marking the fourth consecutive increase. Deutsche Bank's analysts wrote on Jan. 14 that spending by U.S. states and localities during the third quarter point to a turnaround. And in Illinois, one of the states where the fiscal crisis has been most pronounced, Governor Pat Quinn signed a bill on Jan. 13 raising the state income tax rate to 5 percent—a 67 percent jump. On Jan. 10, California Governor Jerry Brown submitted an $84.6 billion budget that cuts spending by $12.5 billion."

Perhaps the muni land default-risk / grab-the-yield-while-you-can story is a fascinating one because the case on both sides seems so well reasoned.

The Bloomberg story ends on this note:

"The bottom line: Fiscal distress has set off fears of defaults in the muni bond market. Some analysts see a buying opportunity for the brave."

How brave are you?


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