Whitney’s Armageddon Belied by ’11 Returns
This was supposed to be the year the $3.7 trillion state and local debt market would be rocked by an exploding pension time bomb and “hundreds of billions of dollars” of defaults, according to analyst Meredith Whitney.
Whitney’s Armageddon never came. Instead, munis became the star performers of 2011.
An investor who bought $10,000 of munis the day after Whitney’s Dec. 19 prediction on CBS’s “60 Minutes” television program would have made about $1,050, based on the 10.5 percent gain in the Merrill Lynch Municipal Master Index, which calculates price changes and interest income. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The muni return is better still because interest income is tax-exempt.
Public debt benefited as Treasury yields plunged and investors fled volatile stocks, powering the Merrill muni index to its third-best showing in a decade. As the U.S. economy recovered from the longest contraction since the 1930s, revenue rebounded, state and local governments raised the taxes backing their bonds, addressed underfunded pensions, cut spending and borrowed 30 percent less than the record amount of 2010.
“Politicians have actually done a pretty good job of stepping up and making pretty difficult decisions,” said Lyle Fitterer, who helps manage $28 billion of municipal bonds at Wells Capital Management in Menomonee Falls, Wisconsin.
In the last four fiscal years, states closed more than $325 billion of deficits, according to the National Association of State Budget Officers. All but Vermont are required to have balanced budgets, according to the National Conference of State Legislatures.
Rhode Island lopped $3 billion from pension costs by lowering benefits. California passed a budget with automatic spending cuts if revenue doesn’t meet projections. Illinois raised income and corporate taxes by $7 billion. State and local governments also eliminated 648,000 jobs since their pre- recession heights, according to the U.S. Bureau of Labor Statistics.
“Governments managed through a very difficult budget season,” said Chris Mauro, head of municipal strategy at RBC Capital Markets LLC in New York. “They did what they needed to do. These budgets were balanced with tough love.”
No tally of actual municipal-bond defaults this year comes close to Whitney’s prediction.
Richard Lehmann, publisher of the Distressed Debt Securities Newsletter in Miami Lakes, Florida, counts $24.6 billion, almost five times more than last year. That includes issuers that used reserves to make interest payments.
The figure is far lower when only those that missed payments are counted. By that measure, defaults fell to $2.1 billion this year from about $2.8 billion in 2010, according to Matt Fabian, a managing director at Municipal Market Advisors in Concord, Massachusetts.
Defaults concentrated in bonds of community development districts, nursing homes and other small and unrated parts of the market are “manageable,” said Judy Temel, director of credit research at Samson Capital Advisors LLC in New York.
Not only did the municipal market survive Whitney, it shrugged off the bankruptcies of Harrisburg, Pennsylvania, and Jefferson County, Alabama, the largest for a government in U.S. history. The failures were the culmination of years of fiscal stress and were anticipated, Temel said.
Nor did the market falter when Standard & Poor’s stripped the U.S. of its AAA credit rating, raising the possibility that top-ranked state and local borrowers would be downgraded as well. It also withstood a congressional committee’s failure to agree on steps to reduce the U.S. deficit, which may trigger billions of dollars of cuts in federal aid to states.
Yesterday, the yield of the S&P National AMT-Free Municipal Bond Index fell to a record low of 3.37 percent.
“The relative high quality and diversification seen in the municipal-bond market has created an avenue for investors seeking safety, less volatility and comparably good yields,” J.R. Rieger, vice president for fixed-income indexes at S&P, wrote in a research note.
To be sure, concerns about U.S. public finances remain. Many states and cities are still grappling with budgets squeezed by the 18-month recession that ended in June 2009. Rising costs for health care and the impact of federal deficit cuts will also weigh on future budgets.
Thirty-three states had pension assets last year of less than the 80 percent considered adequate to pay benefits, according to a 2011 study by Bloomberg Rankings. Median funding fell to 73.7 percent from 76.2 percent in 2009, the data show.
And while state tax collections in the third quarter rose 7.3 percent, according to the Albany, New York-based Nelson A. Rockefeller Institute of Government, they remain below peak levels of 2007 and 2008.
For 2011 at least, the 10.5 percent total return of municipal bonds beats Treasuries, which earned 9.6 percent, and corporate debt, up 6.9 percent, Merrill indexes show. The S&P 500 (SPX) stock index has fallen 3.3 percent, while the S&P GSCI Spot Index of commodities lost 2.2 percent.
When returns are adjusted for price volatility, municipal bonds returned about three times more than corporate bonds and twice as much as Treasuries, according to Bank of America Merrill Lynch and Bloomberg data.
The outperformance comes down to supply and demand, said Matt Dalton, who oversees $925 million of munis as chief executive officer of Belle Haven Investments Inc. in White Plains, New York.
“Demand has continued to increase in part because we haven’t had the multiple defaults that Meredith pointed to,” Dalton said.
After suffering $44 billion in withdrawals from November 2010 through May 2011, tax-exempt municipal-bond mutual funds have taken in about $8.3 billion through Dec. 7, according to the Investment Company Institute.
That’s as individual investors, who make up 75 percent of municipal-bond holders, pulled $153 billion from stock funds in the last 7 1/2 months, according to the ICI.
At the same time, state and local borrowing fell to $285 billion this year from $407.7 billion in 2010, RBC’s Mauro estimates, as officials put off capital projects and the federally subsidized Build America Bonds program expired.
Tax increases in high-wealth states such as New York and Connecticut reinforced the benefits of municipals, as did low rates on taxable securities. The yield on top-rated 30-year tax- exempt bonds exceeded that of comparable Treasuries in all but 10 days of the year.
“Munis make too much sense versus CDs, corporates and Treasuries,” Dalton said. “When you’re looking at 10-year Treasury bonds at 2 percent and you can buy a 10-year muni bond at 2 percent, a taxable buyer moves to the tax-exempt side of the ledger.”
Whitney, 42, gained prominence after her 2007 prediction that Citigroup Inc. would cut its dividend because of mortgage- related losses proved correct in 2008. Her recommendation to sell bank stocks before the credit crisis hit with full force propelled her to fame. Fortune magazine dubbed her “The Woman Who Called Wall Street’s Meltdown.”
She said last year after her September report entitled “Tragedy of the Commons” that state and local borrowers had too much debt and were a systemic risk to financial markets. She didn’t return a telephone call or respond to an e-mail seeking comment yesterday.
Part of the reason the municipal market performed well was because of, not despite, Whitney, said Priscilla Hancock, municipal strategist at JPMorgan Asset Management.
In the fourth quarter of last year, Whitney’s doomsaying collided with rising debt sales stemming from the soon-to-end Build America Bonds program to depress the market. That helped spark the withdrawal of $20 billion from municipal-bond funds in the quarter. By the end of April, investors had pulled out another $23 billion.
Merrill Lynch’s Municipal Master Index lost 4.5 percent in the quarter, the most since the first quarter of 1994.
“This set the market up for good performance as those factors changed,” said Hancock. “The market benefitted from both low rates and from a correction.”
Investors chasing 2011’s returns will be hard-pressed to get them in 2012, said Fitterer of Wells Capital.
“That’s the sad part,” he said. “They got out of the asset class when there was great value, and now in some cases they’re buying back in when the numbers look good again.”
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