Why Munis Are a Great Opportunity

Market turbulence has always pushed market participants seeking safer investment vehicles to bonds. This time, the trouble is that the bond market has seen dramatic demand, pushing yields low and making them unattractive. Stocks are obviously a no-go for risk averse investors, so the question is what does one invest in today?

For technical analysts, resist the urge to start charting. The heavy selling at the end of February was the result of technical factors while the underlying value of municipals are solid. For the first time ever, munis are consistently out-performing Treasury yields. Typically the yield ratio between munis to treasuries was about 85 bps, whereas recently we have seen this ratio rocket up to 125 bps.

So what caused the recent sell offs in particular?

Hedge funds and other somewhat sophisticated investors have been going long on long-term bonds and financing these positions by borrowing through short-term municipal instruments. Before the credit crunch, hedge funds were making money as long as the change in the value of their bonds were greater than the changes in the value of their hedges. Afterwards however, the fixed rates they were paying ended up being worth less than the floating rate they were receiving in the swaps market. Furthermore, investors have been unloading muni bonds in favor of municipal auction securities which are selling near their fail rates. These events have created great opportunities which can easily be invested in through something as simple as a mutual fund.

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To tie this into events you may be more familiar with, Bear Stearns was a big player in the credit default swaps market. It wasn't that BSC was too big to fail, it was the fact that they were too connected to fail.

The CDS market premiums had been trading previously at around 34 bps and spiked up to over 175 bps in March. While it has come down a bit this month, these premium spreads indicate market worries over the coming wave of bond defaults.