Bogleheads

[brainstem]

The other thread was getting too long -- Posters have been wondering about whether the rapid decline in muni bond prices indicate a buying opportunity -- Bill Gross has alluded to this period as a unique opportunity -- BUT - just how much unwinding in needed before the disruption of a formerly staid corner of the investment world normalizes?

Today's FT hints that it more forced selling (and lower prices) is the near to intermediate term forecast:

http://www.ft.com/cms/s/0/9f43....fd2ac.html

http://www.ft.com/cms/s/548066....fd2ac.html

[Nemo2]

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[grayfox]

Like everything else traded in free markets, the price of Muni bonds is determined by supply and demand. With that in mind it seems to me there are four factors that affect the price of Muni bonds:

1. The general level of interest rates represented by the risk-free Treasuries
2. the perceived credit quality of the bonds presented by the spread between Munis and Treasuries
3. Marginal tax rates
4. Liquidity, either excess or lack of.

Factors 1, 2 and 3 are steady state factors that drive the price in the long run. So in the steady state maybe AA Munis trade at 75% of treasuries given current tax rates.

The third factor is a transient phenomenon. When a hedge fund needs cash to pay off an obligation they are forced to liquidate assets at any price. This is like a temporary supply shock which drives down the price below the steady state determined by Treasuries and credit quality. (The opposite can also happen. Cheap money can provide hedge funds with excess liquidity.)

So the analysis should focus on the transient effect. It would be necessary to determine how much cash needs to be raised to pay off loans or redemptions to see how many Muni bonds will be dumped on the market. And then figure out what price will clear the market and how long it will take get back to steady state prices.

But nobody really knows these things. If you were forced to liquidate you would be secretive about it to keep from getting killed. So bond traders are going to be trying to get intelligence about who owns what, and who is in trouble and has to sell, and then guess and place bets.

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[grayfox]

Here is what I think is happening with Muni bonds:

1. Treasury yields have been down recently with flight to safety.
2. There haven't really been any significant credit downgrades except for some that AA Munis that got AAA rating through insurance
3. Tax rates haven't changed.

So the steady-state yield on Muni's should be about flat or even down slightly. But,

1. Auction Failures in Auction Rate notes in the past few weeks caused interest rates to get set at high rates for the borrowers
2. So the borrowers are converting their auction rate notes to regular long-term notes which means a big increase in supply of new Munis driving down the price.
3. Hedge Funds that are long munis and short Treasuries who make money when the spread widens instead are losing money as the spread narrows. Since they are leveraged, they got margin calls and are forced to liquidate their Muni bonds at any price to meet margin requirements.

There is an avalanche effect. The lower price goes the more bonds they have to sell driving the price lower still. So now tax-free Munis are yielding more than Treasuries. Eventually, leveraged hedge funds will have no more bonds to sell and things will stabilize.

[allenmickers]

My prediction is that we will see an approximate 3 to 5% boost in the value of Muni Bonds within the next 3 weeks.

I am basing this on the quick drop in muni bonds recently, meaning that a correction on the upside is likely in order. I believe the quick drop was due to panic selling and hedge fund companies forced to liquidate them, and when the market sees how great of a buying opportunity they are now - giving an equivalent of about 6 to 7% rate of a taxable AAA to AA bond, the price will stablize and move back upwards quickly.

My second assumption to this 3 to 5% boost is the fed scheduled meeting on march 18th which will likely lower interest rates yet again, because historically thats what they do when the market is tanking. The housing market is taking a crap too so the only way to boost that market is to lower interest rates to make overall monthly mortgages on new home purchases feasible. Lowering the interest rate would also let banks borrow money cheaper to cover the defaulting subprime loans they have outstanding.

I put my money where my mouth is and put approximately 80% of my play money into muni bonds on friday

[Paladin]

[Paladin]

I asked this question in another thread:

Given the declines in NAV for Vanguard muni funds is this not a good opportunity to TLH? If not why not?

I'm surprised no one has pointed this out and so I wonder if I am missing something.

Thanks.

- Paladin

[allenmickers]

[Paladin]

[allenmickers]

[Paladin]

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[baw703916]

A couple new articles on the muni price anomaly:

From WSJ (3/1/08):

Hedge Funds' Fire Sales Send Muni-Bond Yields To Historic High Levels