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BENEFITS BEAT
Play the MOB?
Is now the right time for public pension funds to own municipal bonds?
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In case you haven't been paying attention, the municipal bond market is a mess.
With the economy weakening, the credit quality of municipal bonds has deteriorated as property, income and sales tax revenues are sure to decline. More importantly, the municipal bond insurance industry is upside-down because the guarantor companies made dubious decisions in recent years to venture beyond their core market. These companies have entered into the dicey game of guaranteeing exotic mortgage securities, which have gone sour. With credit quality now a crisis, investors have gone on strike, and recent auctions for muni bonds with short-term rate resets have failed — no buyers at any price.
Meanwhile U.S. Treasury bonds have become darlings on Wall Street as global investors seek the safe haven of federal government bonds. It's called a "flight to quality." The resulting difference in market interest rates on municipal bonds and those for U.S. Treasurys — known in the trade* as the "MOB spread," for "municipals over (Treasury) bonds" — has created a rare market anomaly. Municipal bonds are exempt from federal income taxes and normally should yield less than Treasury securities. After all, who wants to pay 35 percent federal income taxes on federal government bonds when tax-free municipals are paying almost as much? Normally, the ratio of municipal yields to Treasury yields is about 85 percent, which reflects the super-safety of Treasury bonds vs the tax exemption of muni bonds. But in today's upside-down credit crisis markets, the yields on many municipal bonds have now overtaken those of the U.S. Treasury. That's a true MOB spread — municipals over Treasurys even though they are tax-free.
This development has not gone unnoticed. Major market gurus like Bill Gross of PIMCO have pointed this out as a once-in-a-blue-moon development, and have recently made huge purchases of municipal bonds for their clients and funds.
I pointed out this possibility in my 2008 market outlook that appeared in January, and the MOB differentials have since become more attractive for pension funds. Ordinarily, there is no reason for a tax-exempt pension fund to buy tax-free municipal bonds, but these are not ordinary times. In the coming months, I will not be surprised to see more pension funds, both public and private, nibbling at these "relative values" in the municipal marketplace.
One particular opportunity could be for pension funds, with long-term money to invest, to step into the short-term variable-rate muni auctions and buy paper that nobody else wants. Yields earlier this month were well above 10 percent, and until the market settles down, there could be more such opportunities. Of course, the credit crisis will eventually subside, and these short-term yields will evaporate. Then investors will have to go elsewhere with their money. Hence, some advisors prefer to see their clients locking up long-term rates that can be held throughout this economic malaise.
The downside of these strategies is that inflation is returning at a time when the dollar is sinking and commodities are in high demand throughout the developing world. Muni yields of 5 percent won't look so good if CPI inflation creeps much higher. At that point, it won't matter if the MOB spread is positive, because the bonds will go underwater in price to compensate for inflation risk.
This is a clear case where it pays to have shrewd, agile, experienced bond managers serving your pension fund. Those who were around in the 1970s and survived the New York City fiscal crisis are probably better prepared to deal with the unknown problems that may yet emerge in hitherto "safe" jurisdictions, such as California, which now faces a whopping $15 billion annual budget deficit. Supply and demand determine municipal bond yields, and it's almost a sure thing that the supply of munis is doomed to increase in 2008 as states and municipalities watch revenues erode and issue more debt to tide themselves over. The MOB spread could widen even more, rewarding those who wait. But in two or three years, I suspect that those who dump Treasurys for municipal bonds nobody wants in 2008 will be rewarded for their patience.
* The MOB spread originated in the 1980s at the Chicago Board of Trade, where a futures contract on municipal bonds was traded for a decade, and the traders would make bets on the differences in price variations of the muni and Treasury bond contracts.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. More biographical information.