In other words, there are lots of very good reasons why we might see substantial price decreases on muni bonds, even without any fears of default. All you need is the retail bid to go away, which happens for all manner of reasons: fewer bonds are being insured, for one thing, and also individual investors are generally smart enough to know that they’re not remotely sophisticated enough to judge creditworthiness on their own. Muni bonds have always been a safe investment with tax advantages; now, they’re something else. They’re much more volatile (ie, less safe), and the market is showing (in this nifty Financial Times graphic), that there’s substantial credit risk where none was really considered to exist in the past. In other words, there’s risk in these things, and muni investors tend to be extremely risk-averse.
It makes sense, then, as the FT reports, that there’s a lot of interest in shorting the muni market, even among people who don’t take Meredith Whitney seriously at all:
“There is a lot of blood in the water in the municipal space. Hedge funds smell that blood and are trying to figure out the best way to make money in the marketplace,” says Rob Novembre, head of municipals at Arbor Research and Trading…
Citigroup, for example, is studying a structured bond which would be directly linked to the performance of the municipal bond index, called MCDX.
This is clearly bad news for municipal issuers: investors wanting to buy the muni market on dips will now have a more liquid alternative to buying actual bonds, and can buy Citi’s synthetic instrument instead. Already the rise of muni ETFs has exacerbated volatility in the market. Expect the muni market to become more financially sophisticated in coming months, with a corresponding uptick in volatility. This is going to be a very bumpy ride for anybody issuing general-obligation bonds, even if there isn’t any signifiant default risk. Just because you’ll pay the money back, doesn’t mean you can borrow the money.