Muni Bond Yields Are Pumped for a Reason


The savviest financial advisor we know has been buying municipal bonds hand-over-fist, but this time we can’t say that we share his confidence. Our friend Doug is a bear’s bear, an outside-the-box thinker and a full-throated deflationist who has contributed occasional commentaries to Rick’s Picks. Moreover, during the years we’ve know him he has done exceptionally well for his clients in good times and bad, even when his employer was breathing down his neck for going boldly against the crowd. When we spoke with him last week, he’d just put the finishing touches on a large purchase of tax-free munis with effective yields as high as 7.5%.  Wasn’t he worried that such juicy returns implied rather substantial risk? Not at all, he replied. The muni bond markets are so spooked right now, he says, that they are ripe for buying.

We're big fans of N.J. Gov. Christie but if his take-no-prisoners approach to budget-cutting were to succeed nationwide, it would bring on a deflationary depression

We wouldn’t quibble with his description of the markets as “spooked,” but we’ll side with the fear mongers on this one, including CBS 60 Minutes.  In a recent segment, the weekly news show reported that as many as 100 U.S. cities could default on their municipal bonds. That’s because they’ve spent almost half a trillion dollars more than they’ve collected in taxes, running up current pension shortfalls of $1 trillion in the process. The scary implications of all this red ink haven’t been lost on investors, who have been dumping muni bonds heavily for the last two months. As bond price have fallen in the panic, yields have risen commensurately.

Rescue’ Fallacy

Some say the sellers’ fears are overblown and that the actual chance of default by a major city is low. States would come to the rescue before any big cities are allowed to go belly-up, say the bond bulls.  We disagree, since the states themselves are in horrendous financial shape and in no condition to bail out strapped cities and counties.  We also reject the argument that the Federal Government could intervene directly to save the day. While such a bailout by the U.S. is theoretically possible, in practice it would put us on course for hyperinflation, since an open-ended commitment to redeem all pension obligations would require many tens of trillions of dollars. That is the Catch 22 of a Federal bailout of cities, counties and states, by the way – that it could only be done using confetti for money. We needn’t even consider what would happen if the bailed out benefits were indexed to inflation.

Doug’s bullish arguments avoid the dead end of bailout talk. He says that the cities have it well within their power to bring budgets into balance, and quickly, and that’s why muni bonds will pay off on-schedule over the long haul. It’s just a matter of cutting benefits and raising taxes, he says, and this has already begun in earnest, most notably in Gov. Chris Christie’s New Jersey. We have a few problems with this line of thinking, however. For one, raising taxes can only proceed so far as this Great Recession continues to deepen. Ultimately – and we mean a year or so down the road, not five years – raising taxes will be like trying to squeeze blood from a stone. Bear in mind that property values are still falling and that the reduced assessments that are coming as a result would necessitate implausibly steep increases in tax rates. As for reducing benefits, Doug says a tidal shift is about to occur that, for one, will transform public-employee pensions from fixed-benefit plans into 401(k)s, shifting the savings burden from employer to employee. This is surely going to happen over time, and in a big way, but any attempt to urgently accelerate the process would turn the asphyxiating asset deflation we’ve endured so far into a full-blown deflationary depression that kills prices, wages and consumption.

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  • david January 5, 2011, 4:04 am

    the Chinese are already backstopping the faux euro damage…China europe japan usa alot of different problems and philosophies but like any system ..The sum is greater than its parts.They are not moving in unison,not that they ever were but enough like with your inlaws you do what you have to ,to keep peace.The amputation or divorce has been declared and a orderly globally coordinated debasing or maintainence of devalued currency is done.Mario cause 3 multinationals are fine don’t mean squat…The multinationals are the stronger piece of this puzzle. The countries, states ,provinces and their increased aging welfare dependent populations can not be sustained and were never built to sustain.All of you are generalists because this is all part of a global changing of the financial system unfortunately its being attempted with the massive view of the concerned and somewhat enlightened populace due to the wonders of the internet and the blogosphere.Add to it a change in how we choose to get our info …and you have a tug of war between the global oligarchs and the frustrated masses.Played out in the theater of the absurd…It will happen im the blink of an eye or should i dare say the click of a mouse.

  • Rich January 4, 2011, 5:59 pm

    Aloha All
    Let me start by noting gold -$37.30 suggests
    Look out Below margin calls.
    Then, having trained at Mother Merrill on the Institutional Muni desk, note that there is a world of difference between General Obligation Municipals secured by the State with taxes and borrowing power, what Doug may be buying, and Municipal Project Notes secured by project revenue.
    Jerry Brown about to announce his $70 B shock and awe burn and slash program for California.
    Having just completed Gary Shilling’s magnum opus on Deleveraging and posted a commentary on JP, suspect both may ultimately be a case of hiccups down the hill, albeit with some good bear market rallies.
    At some point QE hopium no longer works…


    The “world of difference” between general obligation bonds and revenue bonds may be shrinking, just like the power to tax and borrow. I’ll take the revenue bonds myself, since, four years into the Second Great Depression, the revenue assumptions are bound to be extremely conservative. RA

    • VegasBob January 4, 2011, 8:59 pm

      That depends, too. If the ‘revenue’ is predicated on tourist sales taxes (common in FL) or gas taxes/tolls (common for road bonds), the ‘conservative’ revenue assumptions may still lead to default.

      For muni bonds, my revenue preferences are water, sewer, electric and natural gas revenues – those are the last things people will be willing to do without, so I think those types of revenue bonds are least likely to default.

  • Nitram January 4, 2011, 2:13 pm
  • mario cavolo January 4, 2011, 9:52 am

    As most easily agree cuts will be politically-biased, self-serving window dressing at best, we know that bloated pension payments and other gov’t waste won’t get cut by much if at all. So the guy sitting back now collecting a fat pension is happy and won’t lose it.

    But he will. Through inflation. The slowest slow choke is inflation. It has gone on for decades and it will continue to go on and in the end, that is how all this debt talk will ultimately be fused into the system which will become more and more socialist. The accurate picture of the future for the U.S. is an inflationary, social policy driven society with the 150 million “haves” supporting the 150 million “have nots” as the value of a USD gradually declines by 30%. At some point, the wealthy will have to start paying more taxes to help support the system. American lifestyle will become much more “Asian”.

    The fact that 4%-8% yields won’t keep up with inflation or declining currency value is a given. Historically yields never have and never will keep up with the rising costs of living on planet earth.

    Cheers, Mario

    • Other Paul January 4, 2011, 6:44 pm

      Two thumbs up on your analysis.

      Until the dollar breaks (See Benjamin’s “it’s just that the “dollar” hasn’t been broken by the immense federal budget in all these years”), I’m with you, Mario. Slow and steady inflation is the recipe used by the Fed/Treasury since 1913.

      Uncle Sam absorbed Fannie and Freddie, unofficially, of course, and that didn’t put a dent in Treasury prices. Why shouldn’t Uncle support the States if Treasury prices are unaffected. I’m not talking about Uncle absorbing the whole enchilada of State and local obligations. The Federal Gov’t can back up obligations for current expenses, just like the Federal Gov’t does for households’ current expenses, such as extended-d-d-d unemployment and the perennial transfer payments like food stamps and welfare and Social Security to under-62 year olds.

      Fiat is pretend money and the Gov’ts are playing pretend that debts, and pensions, will be paid in full. Pretend works–and has done so, literally, for a lifetime.

      The Ponzi scheme of issuing increasing debt has worked very well–as long as not too many push the “send” key to sell their bonds at the same time.

  • mario cavolo January 4, 2011, 9:23 am

    Is the country and its states so poor? Has there been a reduction of wealth or a “shift” of wealth? If things are so bad, who are they bad for? Who are they good for? Who are they very good for? Where did all the retail (both store and online) sales come from this holiday season? Why did the factory in YiWu here in China making Christmas ornaments for export to the U.S. just have a season of orders through the roof? Why are my three multinational major player clients, one in IT, one in healthcare diagnostics, one in wind/energy development, all ramping UP biz not down? With the USD declining over time, won’t foreign money want to come in and buy up the cheap munis with juicy yields priced in cheap USD?

    The linguistic flaw which is causing the point to be missed is called “generalizing”.

    I might suggest Doug is buying munis now because he isn’t generalizing. Perhaps, he’s just going against the crowd or speculating, but I suspect he’s looked the issues more deeply and come up with enough good news mixed in with all the bad news.

    There will be an escalating WAR against rising yields. “They” will pull out every trick in the book, direct and indirect, local, regional, national and global, beyond our wildest imaginations to prevent rising interest rates. That’s a fact you can bank on. How in heaven they will be able to balance that strategy against the China led inflation trend is beyond me.

    Cheers, Mario

  • C.C. January 4, 2011, 9:15 am

    Keep an eye on Kali as the ‘test bed’ for Federal aid. Not that it hasn’t been going on under the radar already, hidden under different names/programs, etc. The old-is-new-again governor was sworn in today and he likely doesn’t have a lot of time to make hard decisions. There may be some slashing, but with a highly dependent voting base hanging in the balance and a (Hyper)-Regulatory environment about to engulf the state, he’s not about to Sh!t on the those that voted him in, nor the ones that keep the Marxist ideological wheels greased in Sacramento.

    Keep in mind, there is now a HUGE Socio-Political-Dependency component to spending and slashing that didn’t exist the last time around, 70 years ago. Cuts are likely to be either window dressing, or in areas where political risk/fallout/reprisal is deemed to be low.

    One thing is certain, the underlying fiscal problems haven’t been fully addressed and there aren’t any factories kicking out goods to employ and export our way out of this situation.

  • Keith January 4, 2011, 7:43 am

    [We also reject the argument that the Federal Government could intervene directly to save the day.]

    A play on words wouldn’t you say? The Federal Government WILL bail out any and all state and municipalities. But yeah, it’s not going to save the day. Poor old Humpty Dumpty.

  • Steve January 4, 2011, 7:37 am

    Benjamin, I ‘m not sure I understand the inflationary bent. The loss of funds; non-payment to a party holding a debt creates inflation? Sounds like a sucking sound to me. Or, are we talking a federal union of states frn bailout of the muni-bond holders who belong to the club? I believe it to be a gross belief that bond holders shall never feel the pain – ain’t it SO ?

    And all of this with paper that the Federal Reserve admits is a valueless ‘note’, while Eagles still have ‘value’ established in silver Specie united States Dollars.

    • Benjamin January 4, 2011, 10:23 am

      Hi Steve. And happy new year!

      Anyway, it’s been to my understanding that they set things up so that anyone trying to short bonds would have their fingers “burnt off to the armpit”. I assume this means any kind of govt bond, as they’re all connected. So they would feel pain to the extent that they tried to unload them.

      But why sell them when special privilege allows club members to use the rising price as credit, to cancel out the losses of ever-falling interest payments?

      That’s the “hyperinflation” that I see. Not of money supply, but an exponentially expanding black-hole of debt, for the common man, and credit euphoria for the corporate club members. They’ll never suffer the loses, so long as people act as their (much battered) armor.

      But anyway, that’s to say that muni yields aren’t going to be rising, as Rick’s friend Doug suggests, which is the main point here, I guess (Or maybe, if he be a memeber of the club, it just looks a great buy to him. But I doubt it. He’s talking about rising yields, not the euphorian of continued decline).

      And lastly, gold and silver may better protect the battered armor coated with it, but it will never make the wearer of the armor go away. Or rather, cause them to remove you as a shield. There will have to be revolt for that to happen, and by that I mean…

      People, whether they still work or are retired or even on welfare, are going to have demand payment in gold and silver, but also make the promise to pay it back in full. This is much easier and possible than it sounds…

      This isn’t the age of the Spanish empire anymore. Heck, it was quite faded back in the good ‘ol days. Might as well be ancient history, for all that the Spanish-milled silver dollar has any utility for anyone living in the past 200 years or so (at least).

      Repay by revaluing the currency that the underlying commodity creates. It’s never been done, as far as I know, let alone allowed to be done by each and every person who holds any monetary metal at all (rather than by kings and queens and congresses etc). Define the currency weight by what people are willing to voluntarily mint and extend as credit to their government.

      Now, we know who has the most gold and silver. It’s the bankers. So they should be more than willing to call it quits in the fiat biz, and, after some much needed and effective charity, let the metals do what they do best and individual power, thus far unrealized, do what it always has been able to do best… decide, in its own best interest what should and should not be. They could stay rich and free everyone in the process.

      Nothing short of a total revolution will save a single person on this planet, even if that soul possesses a mountain of gold and silver not utilized as described. And best of all, it needn’t be a bloody revolt, as it can in fact be something the bankers agree with and would support. And governments, too, on all levels.

      Of course, the pressure to think, cut through all the complacency, and SEE is not here yet. Bloody revolution may come, but in my crystal ball I more foresee broken spirits and naked, dirty slaves, so enslaved they aren’t even whiped to do any work. Yep. Just left to rot in poverty as “excess population” by those same “brilliant” managers who can’t even imagine another way to be a lazy, good-for-nothing SoBs other than to employ fiat and taxation. A compromise with the less than human is not quite so romantic as heroic revolt, but as the saying goes… beggars can’t be choosers, and a permanent way out is, after all, a permanent way out…

  • Benjamin January 4, 2011, 7:19 am

    “Ultimately – and we mean a year or so down the road, not five years – raising taxes will be like trying to squeeze blood from a stone.”

    A small modification, if I may… It’ll be like squeezing blood from a long-since-bled-to death, hemophiliac stone (and then, according to my crystal ball, we’ll get to see vampires feast on water with red food coloring added in).

    Anyway, Rick, I see you’ve once again mentioned the road to hyperinflation starting in muni bond defaults.
    Not that I’m doubting you, it’s just that the “dollar” hasn’t been broken by the immense federal budget in all these years. I just can’t see that 100 or so cities can do the trick, a year down the road.

    Any helpful reading you can point me to would be greatly appreciated. Thanks!

  • Cam Fitzgerald January 4, 2011, 5:50 am

    I have to give Doug credit for having nerves of steel on this one and living by the maxim of buying when others are fearful but I would not be chasing yield at this stage of the game.

    Far from it, I recently got out all together and just got into plain vanilla cash. Depite all the bullish sentiment right now I keep hearing about how many short positions are being set up and my radar is humming. I can bide my time.

    I am concerned though. a correction of 15% right now might just be sufficient to set off a chain reaction and I don’t want to get caught on the wrong side of the trade. If civic pension shortfalls grow worse as a result of another big market setback or unanticipated event then some muni’s are headed for the dumpster and my gut feeling is we are looking at the big one (crash) some time in the next 24 months.

    I could be wrong. I am just not in the mood to play with fire right now and am firmly in Prechters camp. Preservation of capital comes ahead of fleeting gains.

    • Rich January 4, 2011, 6:11 pm

      Right on Cam. But cash does not pay brokers as well.
      Every civilization ultimately banned usury with Sabbatical and Jubilee after they saw the destructive consequences of debt service turning into slavery and deleveraging into destruction. Bailing out bad loans with more bad loans kicks the can down the road only so long before people wake up and scramble for cash…

    • Cam Fitzgerald January 5, 2011, 6:41 am

      Great point. That might just end up being quite a scramble too, Rich. When we consider how little physical or “real” cash actually exists for individuals to hold at any one time you might think of it as gold itself under the right circumstances.

      We will see. I am a strong believer in holding some amount of physical currency should the most unlikely of events unfold. It is only prudent as none of us really know how everything will unfold in the future. As prudent as keeping your shelves and pantry stocked in the event of the worst case scenario I suppose. (Hell, even squirrels have the brains to stock up for a long winter).

      All I really know for certain is this….

      The day “it” hits the fan,..there will not be time to get prepared anymore. We need to do that today, before it is too late. So stock the shelves and keep cash on hand. Easy.

  • redwilldanaher January 4, 2011, 5:21 am

    “Moreover, during the years we’ve know him he has done exceptionally well for his clients in good times and bad, even when his employer was breathing down his neck for going boldly against the crowd.” – I’m grateful that you made mention of this Rick. That’s exactly how the “game” works. I have first-hand knowledge of this myself. They allow you to be the most “idioillogically”-reasoned bull at any and every time but should you advise caution, or metals, or “perish the thought” inverse ETFs, and your timing is off, you get to live your life out in a pain amplifier. The “company” won’t have your back and the E & O won’t be enough. Kudos to Doug for doing the right thing for many years regardless. I’m with you though on the Muni confidence. If anyone makes any argument other than that they have faith in the illusionists and the Matrix to support their bullish views, I simply can no longer listen to it. 9% deficits to produce 3% GDP growth within the Kleptogarchy and you’d think that Happy Days were really here again if you listen to these sycophants pontificate on bubblevision. More than likely Doug is suffering from long and repeated exposure to the sickening toxicity that emanates from all matter and zero downpointment energy within that “side” of the business.

  • Jill January 4, 2011, 5:07 am

    Hey, Rick. Fascinating column here, as usual. There is just one thing @ the end that I could not follow. You said that any attempt to urgently accelerate the transforming of public-employee pensions from fixed-benefit plans into 401(k)s would lead to a full-blown deflationary depression. How/why would that happen?

    It seems that these counties, cities & states do not have the money to contribute to the pensions currently. If they switched to 401K style pensions, at least someone would be contributing, so that in itself would be better than what is now happening. Do you come to your conclusion because there would be less consumer spending if government employees contributed to 401Ks, because that 401K contribution money would no longer be available to spend, as it is now?


    Less household spending money. RA