Perspective on the Bond Market Turmoil

These changes are unprecedented and will ultimately represent some excellent investment opportunities. Nevertheless, because the changes also impact your holdings you should know what to expect going forward.

Economic Background
The housing market meltdown that we forecasted and discussed at length in previous newsletters continues to plague financial institutions. The losses are so significant, they are affecting the availability of credit – many banks and brokerage firms are restricted from lending in order to meet industry/regulatory standards for risk-adjusted capital ratios.

It is noteworthy that the losses on mortgage-backed securities are based on the market’s forecast of future losses. As the actual losses occur, the economy will slow and jobs will be lost, which will feed additional losses on residential real estate as well as credit cards, autos, and other consumer sectors. Business and commercial real estate loans will be hurt as well. No one really knows how big this snowball of losses will become.

Housing prices will stabilize when home prices represent good values as rental income. What price levels will stabilize residential housing for a given area? My best guess is when the property buyer can get a 6-8% gross, leverage-free return when renting the house.

Bond Market – Quadruple Whammy
Whammy Number 1. The municipal bond market has been negatively impacted by the near collapse of municipal bond insurance companies. These companies provide an extra layer of protection to bond holders by promising to pay principal and interest on the bonds if the bond issuer cannot. In practice, municipal bonds without insurance are among the safest bonds (safer than corporate bonds) because few ever fail to pay, and those that do fail typically recover most if not all of the principal (and often interest) for the bond holder. Bond insurance helped municipalities lower the interest they paid for debt, thus saving taxpayers money.

The problem is that the bond insurers decided to insure mortgage-backed bonds because they could charge higher insurance premiums by doing so. The insured mortgagebacked bonds are now incurring substantial losses because of foreclosures, and the insurance claims for repayment will likely be in the billions of dollars. These losses threatened to eliminate the insurers’ AAA rating and hence the AAA rating of all the bonds insured by the same insurer. Some improvement news: the bond insurers have recently raised more capital, which will help maintain their AAA rating, although many are not convinced that the capital raised will be enough.

Whammy Number 2. Friday, February 29, was an extremely stressful day for municipal bonds. That day hedge funds were forced to sell large blocks of bonds because the hedge funds had made bad bets on the direction of interest rates. The forced selling raised interest rates on bonds to historically unprecedented levels relative to treasury yields.

Whammy Number 3. The short-term financing strategies used by municipalities and other institutions have created further turmoil in the bond market. These institutions borrow money short term to take advantage of the lower rates and for short-term needs. (Consumers do the same thing by using credit cards; the money is free if you pay it off monthly.) Every 7 to 35 days, investors lend money to these institutions through an auction that determines the interest rate that the borrower will pay to investors. If not enough investors want to lend money to the borrower, the auction fails. Brokerage firms that pioneered this type of financing had said that they would step in if not enough investors showed up for the auction and it failed. Well, auctions are failing all over, and brokerage firms are not stepping in because they’ve lost too much money in mortgage-backed bonds. Investors, who up until recently thought that these securities were a good short-term investment are finding they cannot sell out when they want to.

Whammy Number 4. Some municipalities are being caught in the housing mess because of declining property values, declining property tax revenues, and in some cases risky financing strategies. Vallejo, California, which in January had the seventh highest foreclosure rate out of 229 metro areas, was considering filing for bankruptcy, Chapter 9, because of declining property tax revenues. What does it mean for Vallejo bond holders? (MCS doesn’t own any.) It’s not as dire as it sounds for bond holders. In Vallejo’s case, taxes go up, services get cut, and employee compensation may be reduced. A last-minute deal with union leaders avoided the bankruptcy filing (80% of Vallejo’s budget costs were in police and fire department salaries and benefits).

Bottom Line
The current turmoil has caused tax-free interest rates to be at historic highs relative to other interest rates. High-grade tax-free municipal bond prices, however, have not gone up in value as they typically do under times of stress. Overall they have declined about 1.5% since the beginning of the year. This loss is still good relative to stocks, which have declined over 10%. However, normally in a recession municipal bond prices would be up about 2-5% under these conditions.

I believe that municipal bond prices will revert back to their normal strong positive performance at some point during this cycle. Tactically, though, I’m expecting some additional buying opportunities. Forced sales by institutions seeking to reduce their debt by selling their high-quality bonds will lower prices.

As the Wall Street Journal noted on March 11:

“Market participants noted significant selling of mortgage bonds guaranteed by Fannie Mae and Freddie Mac from leveraged investors seeking to raise funds to meet margin calls. A list of municipal debt for sale also made the rounds, traders said.”

The joke making the rounds with bond traders: “Who is this guy named Margin, and why does he keep calling me?”

Interestingly, taxable municipal bonds have performed much better. This doesn’t make a lot of economic sense, but it points to how current financial stresses are contorting the bond markets.

—Michael Stalker, CFA 13 March 2008