Wednesday, February 5, 2014

Relative Value Opportunity in Muni Bonds?

I wrote a couple years ago about the fifty state tax experiment that is taking place right now:

"consider a division of the country into zero income tax states with stingy welfare regimes that productive people flee to, and ultra high income tax (double-digit %) states with crippling regulation that productive people flee from, in the context of Bill Bishop's Big Sort. Which states' muni bonds do you want to own? Which states do you want to own property in? What if a group of these productive states issued a currency?"
Muni bonds would be a good way to implement this bet. A California or New Jersey muni closed end fund yields the same or less than an Arizona or Texas CEF!

Look at these maps: Annual Income Lost/Gained due to Interstate Migration as a Percentage of State Income, 2009 and State Debt Per Capita, Fiscal Year 2009. Also, Annual Income Lost/Gained Due to Interstate Migration, 1999-2009.

MI, NY, NJ, IL, CA are deep in debt and losing productive population to low-tax, low-debt, low-regulation FL, AZ, TX, and southern states.

A correspondent observes,
"Conservative old money goes to munis when retail gets too excited. Sells them at the bottom and buys stocks. Works every time."
The investor base for munis is retail investors in high tax brackets, but many of them sold out last year because of Detroit and Puerto Rico headines, and because the conventional wisdom is that interest rates can only go up. So yields went up and the closed end funds are trading at discounts to NAV.

Meanwhile, there's basically a red/blue state divide on credit quality. The blue "failure states" are losing tax base and population to the pro-market states with natural resources. This is not priced in to the yields at all.


Nathan said...

There's definitely a big difference in credit quality between your examples, but in the context of CEF yields isn't that offset by the use of bond insurance (and obviously differing state income tax rates)?

John said...

Nathan, I believe the point of CP's post was that munis in the right states are a better temporary hiding place than either cash or treasuries when one decides to exit stocks in an overvalued market. In other words the yield is better and the credit quality is good enough if you pick the right states and municipalities.

But obviously if you live in a very high tax jurisdiction like NYC you have to throw after tax yield differentials into the mix.

As for bond insurance, it is priced on past experience and assumes that the states (CA,NJ,IL, etc.) that are on federal life support will continue to be supported by Fed. gov., a reasonable assumption perhaps in the very short run but then completely unreasonable over a 10 - 15 year time horizon if current trends continue.

Nathan said...

Understood, and I completely agree with CP's perspective on the "fifty state experiment".

My point was only that muni CEFs might not be an effective instrument to observe/exploit the differences between states. Take for example the holdings of NKX [1], a CA muni CEF. CA state GO bonds only represent 2% of the portfolio while 50.4% of the holdings are rated AA or AAA, which is higher than CA's state rating of A.

While these individual issuers are likely to be influenced by the finances of the state, it's unclear whether that effect is stronger than other factors. For example CA could change its credit rating overnight by rescinding Prop 13. I realize that's unpopular today, but it's the kind of thing that would be be put on the table before CA goes bust.


John said...


Agreed as to CEFs, and I might add that repeal of prop 13 is a near certainty and would devastate property values in CA in the medium term by forcing sales by all those would could not afford to pay 3% on current market value. Having lived in Newport Beach for most of my working career, I know that there are hundreds of thousands (perhaps a few million) who would have to sell.

But even if prices in prime residential areas were cut in half, repeal would raise a ton of revenue by raising the tax rate from 1% to 3% and increasing appraisals on long held properties up to FMV.

State "bail ins" will take a predictable form.

But by then who knows where interest rates and the SPX will be.

CP said...

Some of the CEFs own insured bonds, but some seem to have hardly any insured bonds at all.

Here's the real question: why on earth is anyone buying the S&P 500 at a dividend yield of 2% and a duration of 25-50 years when you can buy munis that yield 5% with a duration of under 10 years!

CP said...

Yes, Nathan, the CEFs are just a rough benchmark. The point is that the market doesn't have much of a price difference between the blue collapse states and the red states that are having an influx of rich refugees.

So the muni market seems like a place where you demographic success is not priced and where investors are much more pessimistic than equity investors.

Win win!