Just when you thought it was safe to back in the water…here comes the shark again…in this case muni bond ultra bear Meridith Whitney. Whitney is back in the spotlight again renewing her call for massive defaults in municipal bonds. Absolute Returns (AR) did a great screencast the other day summarizing Whitney’s renewed call and the reaction to it. It’s worth watching and reading the associated links. Below is the AR email.
The muni bond market has recouped nearly all the losses it has seen since Meredith Whitney made a high profile call last year. A forecast of massive muni defaults helped push the market lower and judging by fund flows scared a lot of investors out of muni bonds. Whitney is out again today with another look at the mounting danger of muni pension deficits. What is maybe more illustrative is the danger of trading headlines. It is one thing to take into account the views of a prominent analyst, it is another thing altogether to let their views cloud your own judgment. In today’s screencast another look at the muni bond market.
Items mentioned in the above screencast:
Meredith Whitney is sticking with her bearish call on muni bonds. (WSJ)
The muni market is shrugging off Whitney’s most recent comments. (MarketBeat)
Tax revenues are rising, just not fast enough for incumbent politicians’ tastes. (Daniel Gross)
New investors have jumped on the opportunity in muni bonds. (Big Picture)
The muni finance story will play out over a long time. (ValuePlays)
Muni bonds have regained nearly all of their losses. (ETF Replay)
Back at the end of January I posted on the muni bond sell off and how it represented a great contrarian investment. Even if Whintey is right markets tend to over react and that over reaction presents opportunity. One of my favorite investment sayings goes something like ‘the market is the only store I know where people rush out of the store when everything goes on sale’. Well, munis definitely went on sale. Since then they have had a nice bounce back. I love this chart below because it marks when Whitney made her call.
Beware of experts! The point of the this post is not talk about Whitney’s call. Obviously, she has been wrong so far and many people are gloating. She is sticking to her guns. She still could be right. Personally I think she is very very wrong. But that is irrelevant. I wanted to talk about how an investor can judge if the market reaction to some event is over done or not. Why did I think munis were a good buy back in late Jan? When an event like this happens an investor should ignore the headlines and look at the data with goal being to judge if the market over reacted or not. In the case of muni my analysis back in Jan is shown below.
I modeled three scenarios. Two Whitney scenarios, $100B of defaults in 3 years and $300B of defaults in 5 years, and a milder scenario by Roubini. Whenever you find ultra bear Roubini as a mild scenario you know you’re being conservative. I then took the tax free yield on several muni CEFs that were trading and discounts and looked like good investments. To compare them to other potential investments I then converted the yield into pre-tax equivalents. Next came the default rates. The muni bond market is huge, $3 Trillion. So, defaults of $100B over 3 years works out to be about -1.1% per year for those 3 years. Doesn’t seem so bad now does it? Next, I factored in potential capital gains that would come as prices returned to more normal levels over time. I assumed a moderate 10% capital gain over the three time periods. Then I added all the factors up and came up with a range of total returns ranging from 8% per year in the most conservative case to just over 12% per year in a slightly less conservative case. Those looked like very good risk adjusted returns to me. At that time I took a 5% portfolio position in several closed end muni CEFs. So far so good. I’m collecting a nice monthly check of 7.5% annualized tax free and am well positioned for cap gains. I continue to think these are good investments despite the slight uptick in the CEF prices with yields now at about 7%.
In summary, any any big market event it pays to look past the headlines and look at the underlying data. Many times emotion takes hold of the market and prices over react relative to even the worst case scenarios being painted when properly viewed over time. These times are great opportunities for patient contrarian investors. Who knows who will wind the muni bond war? Personally, I don’t care. The prospective risk adjusted returns are in favor of an investment in muni bonds.