Has the Next Meltdown Begun?

Even as stocks have rebounded sharply from their March 2009 lows, many investors were waiting for the next shoe to drop after the 2008 financial crisis. What's been happening in the usually quiet municipal bond market during November may well be that shoe.

Munis and you
For investors who prefer to follow every move the stock market makes, talking about bonds is apt to get you a roomful of yawns. And even among bond traders, municipal bonds, which states and cities issue to pay for exciting things like sewer systems, pale in comparison to the latest hot corporate debt deal.

But lately, municipal bonds have been anything but boring. The muni market has been plunging so far this month, with yields on long-term municipal debt rising half a percentage point in the past two weeks. Although that rise may not seem like a whole lot, it's a big deal for a usually sedate market, and one analyst referred to it as a "meltdown."

What's going on?
Several things are happening to affect municipal bonds. On one hand, states are rushing to issue new bonds under the Build America Bonds program, which expires at the end of the year. The program pays a federal subsidy to state and local governments that issue bonds, effectively refunding part of the interest they have to pay to bondholders. The rush to get in under the wire has flooded the market with supply.

On the other hand, investors are demanding risk premiums to buy those bonds. Earlier this week, the state of California sold a whopping $10 billion in muni debt, and buyers demanded relatively huge spreads on the short-term securities over safer munis. Across the country, state and local governments are feeling big financial squeezes. Moreover, bondholders who used to be able to rely on muni bond guarantees from the likes of MBIA (NYSE: MBI  ) and Ambac Financial are now having to judge munis on their own merits. Even Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , which only recently entered the market, has cut its new underwriting, leaving Assured Guaranty (NYSE: AGO  ) as the biggest muni-debt insurer remaining.

Moving the markets
Among exchange-traded products, the traditional way to trade munis has been to use closed-end funds. Among closed-ends, recent price moves have been quite dramatic. Just yesterday, several leveraged California-focused municipal bond closed-ends dropped more than 3%. Many closed-ends have fallen as much as 10% or more just since the month began before bouncing back somewhat.

Even more importantly, just as 2008's market meltdown resulted in large inefficiencies in financial markets, the impact of the muni market's breakdown is hitting the ETFs that investors use to trade them. The major municipal bond ETF iShares S&P National AMT-Free Muni Bond (NYSE: MUB  ) traded at nearly a 2% discount to its net asset value Wednesday morning, despite the fact that such a discount should have created an arbitrage opportunity for institutional investors to redeem shares for full value. The smaller Market Vectors High-Yield Municipal Index ETF (NYSE: HYD  ) and the state-specific iShares S&P California AMT-Free Muni ETF (NYSE: CMF  ) had even wider discounts around 3%.

How to capitalize
As savvy investors will remember from two years ago, one person's crisis is another's opportunity. Falling muni prices bring higher yields to those with the courage to buy munis right now. With the prospect of higher tax rates next year, munis could be even more valuable for investors than they are now. And if you think state and local governments qualify as too big to fail, then a federal bailout could benefit bond buyers this time around as well.

One thing I'd like to see before getting excited about the value in municipal bonds, though, is big discounts from net asset value on muni closed-end funds. So far, fund declines have come almost entirely from drops in the value of their holdings, and discounts aren't all that attractive. Until closed-end shareholders panic and dump their shares onto the market in droves, accepting whatever the market will bear for their shares, it's too early to declare a true muni meltdown.

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Fool contributor Dan Caplinger thinks the best meltdown is cheddar cheese over tortilla chips. He and the Fool own shares of Berkshire Hathaway, which is a Motley Fool Inside Value pick and a Motley Fool Stock Advisor choice. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy melts in your mouth, not in your hand.


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