Munis take worst pounding since Meredith Whitney
Investors spooked by possible lifting of tax-exemption; ‘armageddon concerns’
December 21, 2012
The $3.7 trillion municipal market is poised for its steepest monthly decline since 2010 as investors spooked by threats to the debt’s tax-exempt status withdrew the most money in almost two years.
Demand from individual buyers, who own about 70 percent of U.S. local debt, collapsed last week as yields set four-decade lows. At the same time, talks between President Barack Obama and congressional leaders over a deal to avert tax increases and spending cuts set to start in January included measures that may cap munis’ tax exemption. Investors pulled $2.3 billion from muni mutual funds this week, the biggest exodus since January 2011, Lipper US Fund Flows data show.
State and local debt has lost 1.9 percent this month, on pace for the worst return since December 2010, Bank of America Merrill Lynch data show. That’s when banking analyst Meredith Whitney predicted “hundreds of billions of dollars” of muni defaults, helping propel 29 straight weeks of fund outflows.
“So much has changed in a week,” said John Dillon, chief muni strategist in Purchase, New York, at Morgan Stanley Smith Barney, which handles about $150 billion in local debt. “It’s the reality that the exemption is not fully in the clear.”
While Whitney’s forecast proved incorrect and the default tally is set to be the lowest since at least 2009, the selloff in the past two weeks threatens to end a five-month rally.
Muni bonds surged after the Nov. 6 U.S. election, pushing yields to the lowest since 1965 as buyers including Bill Gross of Pacific Investment Management Co bet that Obama would raise the top federal tax rates to curb deficits.
Investors then switched their focus to another aspect of Obama’s policies — his proposal to limit the income-tax deduction on local debt to 28 percent. Analysts at Citigroup Inc. said this month that such a move could reduce the value of the market by $200 billion and cause investors to demand an extra 0.6 percentage point of yield.
Yields on AAA munis due in 10 years reached 1.8 percent yesterday, the highest since August, data compiled by Bloomberg show. The interest rate touched 1.4 percent Dec. 6, the lowest for a Bloomberg Valuation index that began in January 2009.
“The market had been embracing the concept of higher marginal rates and completely discounting any mitigation of the value of the tax exemption,” Dillon said. The yield reversal “makes me think of back when we had the muni Armageddon concerns in late 2010,” he said.
Institutional bondholders such as mutual funds put $1.4 billion of munis up for sale last week, the most since Dec. 14, 2010, data compiled by Bloomberg show. That was less than a week before Whitney’s default forecast on CBS Corp.’s “60 Minutes.”
Munis have fallen faster than Treasuries this month, with local-debt underperforming federal securities by the most since August 2011, Bank of America data show.
The yield on benchmark 10-year munis is about even with that on Treasuries. The ratio of the two exceeded 100 percent this week for the first time since Nov. 8, showing munis have cheapened relative to federal debt.
“Municipal ratios relative to taxables had gotten too expensive,” said Craig Pernick, a senior managing director at Chevy Chase Trust Co., which oversees about $1.2 billion in local debt in Bethesda, Maryland. The company “had not been active at all” in munis in November as yields fell, he said.
Analysts such as Michael Zezas at Morgan Stanley warned this month that buying munis with yields at four-decade lows might be a losing bet.
“The market may be ignoring a real threat of a cap to the muni tax exemption in 2013,” Zezas wrote in a Dec. 4 report.
Efforts to avert the more than $600 billion in tax increases and spending cuts set to start next month deteriorated yesterday. The White House warned business leaders this week that talks between the president and Republican House Speaker John Boehner were regressing.
“Municipals more or less have been a sacred cow that — along with mortgage interest and charities — have not been touched,” Pernick said. “If there’s going to be a grand bargain, municipals may not have that status.”