Dolors & Sense
by Sanford Rose
KISSIMMEE, FL—(Weekly Hubris)—12/20/10—In the first week of this month, investors decided that the municipal bonds in their portfolios were a pile of overvalued junk. So they sold them off, igniting one of the largest declines in value in the history of that market.
What motivated investors to panic and destroy so much value?
What is value, anyway? And why is it so mercurial?
Value, quite simply, is the worth today of what you’ll be getting tomorrow.
Generally, what you’ll get tomorrow is worth less than what you’ve got today. That’s obviously because you don’t have it yet. But it may also be worth less because you’ll never get it.
In any event, what is promised to you in the future has to be discounted to equal what you’ve got now.
Municipal investors reached a consensus that the cash they expect in the future from their bonds needs a much bigger haircut than they previously thought in order to equate to their cash in hand.
That could be because this future cash flow is more problematic than hitherto believed. In other words, there is a greater possibility that it will never be delivered because of the poor credit quality of the bond issuers.
But that seems unlikely. Municipal defaults have thus far been amazingly low, and a prominent financial firm—one whose opinion carries a lot of heft—just issued a report saying that the chances of state defaults are minuscule, with those of city defaults only a shade higher.
No, it isn’t new concerns about credit quality that have spooked the market.
In part, the panic stems from the growing belief that the economy may finally be turning around and, in consequence, interest rates will be rising from the caverns into which they’ve plunged.
This means that the cash investors will be getting in the future has to be discounted by a higher rate because: (1) the demand for funds in a buoyant economy is brisker than in today’s becalmed economy (raising what’s called the real rate of interest) and; (2) the pressure of overall demand on available capacity and supply will increase (raising the specter—currently well-exorcised—of a higher discount for loss of purchasing power, or inflation).
However, it is more than likely that factors specific to the municipal market have increased the size of the valuation haircut investors are administering.
The municipal market has two parts, one taxable and the other tax exempt. In the last two years, thanks to the 2009 stimulus act, the taxable section has grown enormously because the government is empowered to give municipalities a 35 percent direct subsidy to issue bonds that are not exempt from federal taxes.
Suddenly, it appears that the government is not going to be allowed by Congress to renew this authority when it expires at year end.
Lacking the ability to issue these BAB’s, or direct federal subsidy bonds, the states and localities will be forced to borrow in the traditional tax-exempt form.
For most of the last two years, investors, fearing a shortage of tax-exempt paper in a period in which tax rates were slated to rise, have bid up the price of existing paper. Now it appears that there will be a surplus of that paper in a period in which Republicans may be able to prevent tax rates from rising.
Ergo, what could be offered at a low interest yield yesterday looks as if it will be marketable only at a much higher interest rate tomorrow.
So the bonds that were issued at the comparatively paltry rates of most of 2010 are no longer competitive unless given those generous haircuts.
Congress speaks, or threatens to speak, and fortunes disappear (although the opportunity to invest new money—should it exist—at much higher rates re-appears).
T’was ever thus.