David R. Kotok, Cumberland Advisors Inc.’s chairman and chief investment officer believes Municipals Cheap After Detroit Filing
Municipal bonds are an “outrageous bargain” in the wake of Detroit’s bankruptcy filing, according to David R. Kotok, Cumberland Advisors Inc.’s chairman and chief investment officer.
Kotok bases his arguments on a comparison on General Obligation Yields to US Treasuries.
Muni vs. Treasury Yields
More on Munis
In a followup guest post on the Big Picture blog, Kotok offers More on Munis, Detroit, Bloomberg, Whitney & Wilson.
In our recent commentary on municipal bonds and Detroit, we argued in favor of buying the highest-grade AAA tax-free municipal bond It currently yields more than the corresponding taxable US Treasury obligation.
Meredith Whitney, Muni Cassandra emeritus (ae?), weighed in against Munis (FT) and used the Detroit default to say her version of “I told you so.” Bloomberg reported both sides of the argument.
Readers may seek Whitney’s positions and her history of Muni-forecasting on their own. Our position is clear: do the research and buy the bonds that make sense. There are many of them. This is an idiosyncratic market of $3.8 trillion; painting it with a broad brush is a mistake.
We took the position that the default history of the true AAA-rated tax-free municipal bond has the same default history as the US Treasury bond: neither has ever defaulted.
Remember, we are referring to the natural rating of the bond. We are not referring to those bonds that were insured by various bond insurers and thus elevated to an AAA rating because of the bond insurance. Bonds that were rated AAA only because of the insurance have defaulted, but the underlying ratings of those insured bonds always fell below AAA. No true AAA credit ever needed bond insurance to sell a new issue.
Our bottom line: high grade, tax-free bonds are really cheap and their credit support is improving. Score one for Munis; score zero for Detroit; score evenhandedness for Bloomberg media in reporting. We will leave the Whitney scoring to our readers.
The Muni Market’s Shifting Sands
Writer, Mark J. Grant, author of Out of the Box expresses a different viewpoint in The Muni Market’s Shifting Sands, a guest post on ZeroHedge.
I began my career in this space. Fresh off my internship I was assigned to cover small banks in Missouri and Kansas and sell them Municipal Bonds. My fondest recollection was of a small bank in western Kansas that said he couldn’t buy bonds now because, “There are green bugs in the milo.” I had no idea what green bugs were then and wasn’t too sure about milo.
Almost forty years later and having supervised the municipal trading/sales and banking areas at four different investment banks I still am on the watch for the green bugs in the milo.
Detroit is now teaching us several lessons and you can feel the sand shifting yet again. The normal credit analysis performed by many money managers is insufficient in my estimation and because of this losses will be taken. The issue here is the pension funds that may have priority over the general obligation bonds. This is made clear, as an example, in the Michigan State laws and I am expecting new laws and new State and Federal regulations to be passed to guarantee this priority. Pensions will trump the bond holders and General Obligation bonds must now be viewed in the light of a subordinated position. This may shift ratings but it will certainly shift the appreciation of risk in Municipal Bonds and will most probably cause them to widen against both Treasuries and other forms of debt.
General Obligation bonds no longer have the first call on assets.
Specifically, if you are analyzing a Municipal credit, you should look carefully at the size of their pension obligations and calculate the ratio for pension obligations divided by their G.O. debt. Then you should examine the unfunded pension liabilities, add them to their pension obligations and divide that number by their G.O. debt. These calculations will help you get a more realistic handle on the risk that you are assuming when buying the G.O. debt of a municipality. It is not enough, any longer, to examine a Municipal credit in the same way that you examine a corporate credit because Detroit is setting a new standard where pension obligations have the first call on assets and General Obligation bonds have been pushed into a secondary position.
The psychology of the Municipal market is also shifting in the sand. It was once a widely held belief that the State would stand behind any large Municipal credit in its domain. Detroit is proving this to be an inaccurate observation. There was even the notion that if the Municipal credit was large and systemic enough that the Federal government might step in to help. Detroit is exemplifying that this was a second mistake in thinking. We are now learning that each Municipal credit is a stand-alone situation which is a break from the traditional thinking of days past.
I think it is true that Municipalities can meander along longer than corporate credits and certainly than mortgage credits because they can increase their taxes and/or increase what is taxed. So the time-line is longer when a credit is in trouble but, if a Municipal credit falls over the edge, the consequences for debt holders have now become more severe. Detroit brings Chicago to mind and then my caution widens as you look at other large cities. Greater care must now be exercised and I would suggest that many of you should begin a re-examination of what you own and whether you wish to keep owning it.
Expect More Fallout
The fallout in Detroit is not over. There will be more Detroits for sure.
However, we have not seen the final ruling from bankruptcy court. To what extent, if any, will courts rule “General Obligation bonds no longer have the first call on assets”?
I don’t know and no one else does either. Yet, I suspect that both bondholders and pensioners will take a decent-sized hit. A friend emailed a commonsense point of view earlier today.
“Fairness of the pension level is irrelevant. It’s what the debtor can afford. And Detroit can’t afford much. In municipalities, as in private employment, the cost of getting a pension package your employer can’t afford is ultimately that you don’t have a pension package. This will be much tougher than private bankruptcies, though, because the PBGC does not cover municipal employee plans. So the estate of Detroit will have to pay something, because it is intolerable that old policemen and firemen suddenly resort to complete welfare. But it can’t pay much. This will be brutal.“
Three Bad Assumptions
Kotok points out that no AAA rated GO bond has ever defaulted. OK, but have we ever had a pension crisis before?
Please consider three widely-held assumptions on GO bonds.
- Bondholders have first call on obligations
- Taxes can always be raised
- The state or federal government will bail out the municipality
All three of those assumptions are false. And how many bonds are rated AAA because of those assumptions?
Definition of “Cheap”
The top chart shows that munis are cheap compared to treasuries (assuming no defaults). But does that make them cheap?
This is not a position I endorse, but for the moment let’s assume that Kotok is correct. That AAA rated bonds will not default.
Are they cheap? Compared to what?
It depends on the definition of cheap. What if treasuries are not “cheap”? After all, the same chart Kotok showed a few days ago would have shown the same thing at the beginning of May.
10-Year Treasury Yield
Yield on the 10-year treasury rose over 100 basis points since the beginning of May. US treasuries were not cheap then. Thus, the notion of something is cheap compared to something else is a false dichotomy.
At the beginning of May, neither treasuries nor munis were cheap. And what if neither is still cheap? What if the pension crisis shifted the sands? What if widely-held assumptions about AAA and defaults are invalid?
As you can see, it’s not as simple as Kotok’s “GO’s will not default so buy them because they are cheap compared to treasuries” point of view.
Things changed, sands shifted, and right now, we really do not know by how much. So it’s quite the stretch, for numerous reasons, to say munis are an “Outrageous Bargain”.
Mike “Mish” Shedlock