Municipal Bonds Are Unique

Municipal bonds have been in the press more often lately. The Federal Reserve recently published a report on defaults in the municipal market precipitating arguments as to what constitutes a default as well as what constitutes a municipal bond. Such arguments bolster our position that while municipal bonds in the aggregate total almost $4 trillion, the marketplace is highly fragmented and the marketplace is a collection of tens of thousands of unique financial instruments too numerous to count.

When you invest in Stocks you become an equity owner of a company.  You own a piece of the company and generally speaking this is a pro rata share of the company.  As an owner you hopefully accrue the benefits of ownership, most significantly the benefits of dividends from profits as well as the hope of a higher market valuation.  Stocks represent ownership and this is fairly straightforward and well understood.

When you invest in Bonds you are usually promised to be paid back per the terms of the bond.  A 4% bond due February 1, 2027 should pay you 4% of its face value each year (in two semiannual payments) with the face value amount paid back to you at maturity.  This is the “big print” that appears on your monthly statement.  All bonds have these common traits and this is also fairly straightforward.

Municipal bonds have the additional feature of not knowing exactly where the money owed will be coming from.  The city of Dallas does not provide the funds for all bonds with Dallas in their description.  Bonds with Dallas in the name may not even be paid by a municipality at all but perhaps by a hospital or a public or even private corporation.  Thus the money promised to provide for the repayment of municipal bonds is quite varied.

So where or from whom or from what will a municipal bond be paid back?  This is the “fine print” that differentiates the municipal market from other bonds.   In order to determine how a bond is repaid one must look beyond the obvious “big print” that appears on your monthly statement.  This is what we do at The Select Approach^TM.  We look at the “fine print” because it is the “fine print” that determines the credit quality of a municipal bond issue.  Once credit quality can be established we use it to make judgments on the bonds we seek to buy, often dozens of time a day.  These are the decisions we have been making for many years.

So credit quality is the number one issue that must be addressed before transacting in the municipal bond marketplace.  However we also know, and experience (as well as everyone else) tells us, that the risk of default in the municipal bond marketplace is quite low.  Getting to this point of widespread acceptance of municipal bonds has taken many years and certainly needed to address the credit quality question of municipal bonds.  By creating municipal bond insurance, Wall Street gave investors the confidence to buy bigger pieces (they’re insured!).  With bigger issuances came new buyers or perhaps new buyers led to bigger issuances.  Now, with hundreds of billions of dollars in municipal bonds issued annually, large municipal bond investors tend to seek features and structures to give them scalable opportunities.  This formula for success later led to the introduction of leveraged municipal bond investments.  Needless to say, buying large bond pieces and later buying large bond pieces with borrowed money would not be possible in a period of municipal bond turmoil.  Quite the opposite.  Such buying could only occur in a period of municipal bond calm and confidence.

Municipal market credit expansion has been tremendous.  According to a recent SEC Report, there were $235.4 billion in outstanding municipal bonds in 1975.  Today the figure stands at $3.7 trillion!  One would expect a lot of calm and confidence to lead to such expansion and for almost all of the past thirty seven years we have gotten it, but not without bumps in the road.  Whenever faced with financial crises over the time frame, the answer was more debt.  Interesting that the SEC uses 1975 as its start date; it was 1975 that New York City addressed its debt problems by (another issuer) issuing more debt.  While the concept of more debt to address debt problems is not a municipal debt hallmark, we have seen the federal government use the tactic not only repeatedly but with loftier and loftier debt levels.  This is credit expansion.  The concept knows no boundry.  The issuance of debt grows, exponentially in the later stages, until it no longer can.

Over the past several years we are all discovering just how near the end credit expansion may be.  We have witnessed Credit Expansion Finished in the residential housing (mortgage) market.  The effects of the Credit Expansion Finished in housing have already been devastating.  Prices no longer rise; they fall, sometimes dramatically.  The creation of new housing debt no longer flows like water; getting a mortgage is worse than airport security.  But the most troubling aspect is that Credit Expansion Finished occurred in a debt market.  Whereas before the crisis we only had a concept: credit expanded until it no longer could; now we have a poster child example.  We also have a number of other debt sectors barreling toward the endpoint.

Thus the concept of credit expansion applies not only to housing and mortgages, where Credit Expansion Finished is undeniable.  The concept of Credit Expansion Finished will also apply to sovereign debt, such as US Treasury bonds,  Greek bonds and German bunds, but also to Corporate bond debt, student loan debt, credit card debt and of course municipal bonds.  No group of bonds is immune from the effects of credit expansion.  More importantly, no group of bonds is immune from the effects of Credit Expansion Finished either.

We are very familiar with credit expansion as this is “the old normal” to twist a phrase from Pimco.  Credit expansion has been the dominant force not only in the exponential increase in debt in the post-war era but also the means of bailing out entities on the brink of failure.  More debt is always the answer, regardless of the question.  Credit expansion in the final phase gives the greatest confidence (housing prices will always go up).  Credit expansion in the final phase also gives us the greatest security in our wealth (we can always sell the asset or borrow more money against it).

Credit Expansion Finished represents the capitulation in the use of debt.  All of a sudden, seemingly, the issuance of more debt is no longer an option.  Housing prices do not continue to move higher but instead move lower.  The confidence in continued optimism evaporates.  The continued use of more and more debt is over and the repercussions for a leveraged world economy become acute.   The revenues needed to pay back bonds will not continue to grow and just this one fact, which is our current experience in some bond segments, will require (immediate) attention.

It is because credit expansion continues across the remaining bond markets that we are convinced Credit Expansion Finished (and its disastrous after effects) is a fait accompli.  The few gears of Wall Street that are still operating are largely due to credit expansion.  As such, those that invested in the bond markets as they have for many years (go long and go home) continue to look like winners.

Anyone who owns long-term assets such as Stocks, Long-term bonds and junk bonds should realize they are betting with the trend of continued credit expansion.  You should support bailouts, cheerlead for QE3, be pro big Bank, pro big government, pro stimulus, pro higher prices and pro more debt to support such high prices.

We of course believe our existing trek, like housing, will end in Credit Expansion Finished.  It probably won’t happen all at once; it certainly has not for all municipalities.  Credit Expansion Finished has happened to Stockton and San Bernardino and it will happen to more municipalities then we can count because there are too many municipal bonds to count.

Why did housing hit the wall first?  We can’t answer that other than to say some homeowners borrowed more than they should have.  Now it is Credit Expansion Finished for almost all homeowners.   Likewise some municipalities borrowed more than they should have.  If we weren’t close to Credit Expansion Finished in the municipal bond market then we would have seen Stockton and San Bernardino (and others) bailed out with additional credit expansion.  The state of California could have bailed them out with additional borrowing.  The federal government could have bailed them out with additional borrowing.  But this did not happen!  Perhaps it is not too early to declare Credit Expansion Finished in the municipal bond marketplace.

Weak municipal bonds will fail and more will fail as Credit Expansion Finished is realized in the municipal bond marketplace.  This reality is now seemingly upon us.  This is bad news for Wall Street and bad news for millions of Americans who now realize that the can may no longer continue to be kicked down the road.

Unlike the mortgage market where mortgages are held by banks or continue to be packaged by the federal government, unique municipal bonds trade every day.  More and more of these bonds are not worthy of consideration because they have weak security and prices have yet to dramatically fall.  We are patient.  Bonds with strong security do continue to come to market and some of these may provide better than worthwhile opportunities.  As Credit Expansion Finished in the municipal marketplace becomes the known reality we should see dramatically lower prices for municipal bonds as well as more potential opportunities.  This has happened before in the municipal market; it is happening again.  However this time we have Credit Expansion Finished which means fiscal realities will not be skirted like New York City in the 1970s.  Without extending credit, more and more municipalities will fail and the days of confidence and calm in the municipal bond marketplace will be over.  Betting on higher or even firm long-term bond prices is a bet we have chosen to pass on once the housing succumbed to Credit Expansion Finished.  We expect the other bond markets, particularly municipals, to eventually succumb to Credit Expansion Finished and we are therefore keeping our cash near and dear.

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