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Don’t Buy Into the Muni Bond “Fear” Trade

No doubt you’ve heard about the mass exodus from municipal bond funds. Over the course of three months, investors yanked almost $32 billion out of them – the most severe outflow of cash on record.

It’s also in stark contrast to fund flows in 2009 and most of 2010 when investors stuffed more than $100 billion into municipal bond funds.

So why the sudden change of heart? Fear, mostly. Or “pervasive fear,” as one fund manager said.

The biggest fear monger on the airwaves is banking analyst Meredith Whitney. She took to primetime television, saying, “There’s not a doubt in my mind that you will see a spate of municipal-bond defaults.” She estimates the total damage could “amount to hundreds of billions of dollars’ worth of defaults.”

Pure rubbish.

Now let’s cover why. And then I’ll get to the only move you should make in the municipal bond market…

The Sky is NOT Falling!

I’ll concede that a nasty economic slowdown and bingeing on cheap debt has left many municipalities in dire financial straits.

I’ll also concede that default rates on municipal bonds are likely to increase. But they’re increasing from an insanely low historical average of less than 1%.

Even if municipal bond default rates double, triple, or even quadruple, you’re still talking about a manageable level. A level that’s still less than the historical default rate for most corporate bonds.

Plus, do you really think the Federal Reserve is going to let an entire state default, especially one as important to our economy as the state of California? Not a chance.

Not to mention, austerity is coming. In New Jersey, Governor Christie is taking on the unions. Illinois has raised state taxes. In California, billions are being slashed from the state budget.

Add it all up and I’m convinced that the perceived risks in the municipal bond market are being overblown. Selling municipal bonds right now is a classic fear trade. Everybody’s doing it. But don’t buy into it.

For as Humphrey Neill said, “When everyone thinks alike, everyone is likely to be wrong.” I’ve got a more fitting phrase in this case: “When everybody thinks alike, nobody’s thinking!”

Say Sayonara to Muni Bond Insurance

If you’re hell-bent on moving money around in the municipal bond market, the only move I recommend is selling short Assured Guaranty Ltd. (NYSE: AGO). It’s a dodo bird in the making.

Why? Because it insures municipal bonds. That means if a municipality defaults on its debts, Assured Guaranty is left holding the bag. It has to pay the principal and interest on the bonds. (The company provides the same insurance on mortgages, too.)

Being on the hook for municipalities and mortgagees is a big risk. Big enough that defaults have forced all other companies in the municipal bond insurance business, well, out of business. (Ambac filed for bankruptcy and MBIA’s bond insurance unit is wrapped up in nasty litigation).

Normally, being the only company in an industry is a boon to profits. But not in this case. Although Assured Guaranty is writing 98% of the muni bond insurance these days, the market for such insurance has shriveled.

Case in point: Five years ago, about 50% of all municipalities purchased insurance on their bonds. Now that figure stands at less than 10%.

On top of that, cash-strapped municipalities are demanding deals on insurance if they purchase it. More plainly, the premiums Assured Guaranty collects are being squeezed.

Less business. Lower margin business. That’s not a business I want to be in. Neither does Warren Buffett…

Don’t Tase My Rating, Bro!

You’ll recall that Buffett entered the muni bond insurance market in 2007 with Berkshire Hathaway Assurance Co. He’s since exited. And other entrants have done the same.

Add it all up and no matter what happens with municipal bond default rates, Assured Guaranty faces stiff headwinds. Especially now.

Rating agency S&P is rewriting the rules on how it rates muni bond insurers. The proposed changes would require Assured Guaranty to raise an additional $1.9 billion in capital. That’s huge, since Assured Guaranty’s market cap rests at just $2.6 billion.

Management is considering raising the capital via a debt offering to fend off a downgrade. But given the poor fundamentals – Assured Guaranty swung from a $216 million net profit in the fourth quarter of 2009 to a $157 million loss a year later – nobody’s going to line up to lend the company money.

A stock offering is more likely, which will only dilute shareholder value even more and sink the share price. So forget about selling municipal bonds. Sell short Assured Guaranty instead.

Ahead of the tape,

Louis Basenese

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