Are Municipal Bonds Cracking?

Look at last week's price action in PIMCO's Municipal Income Fund ETF (PML).  Municipal bond markets plunged.  Not surprisingly, the California ETF (PCK) shows the most precipitous drop.

It might be argued that muni markets are merely reflecting similar declines in treasuries (TLT).  Fair enough. Bond holders, though, are probably are more interested in the fact that their bonds have declined rather than why they are declining.

Warren Buffet warned back in June on the Muni Bond market. Defalt, so far, have been rare but local and State municipalities are struggling to meet their obligations.

There was a time -- before the 2008 crash -- when triple AAA rated, insured munis were seen as the safest of safe investments.  Times have changed.  Only Assured Guarantee (AGO) still insures municipals but the company has been recently downgraded from AAA to AA.  Ambac (AMBK) is  in bankruptcy. MBIA (MBI) is entangled in litigation and no longer writes new policies.  The financial guarantee business today is but a shadow of its past.

Even though defaults in the muni markets have been rare so far the Feds zero interest rate policy has thrown a cloud of uncertainty over all bond markets.  Declining tax revenues, rating downgrades, loss of insurance, rumors of bailouts, all contribute to uncertainity and suspicion that all is not as well as claimed.

It may be wise lighten up on all medium to long term bonds at this juncture.  Greece, Ireland and Portugal may not be as far removed from New York, Illinois, and California as we might wish.

QE2 or the Titanic?

Someone has awaken the band, found the girls, and broken out the drinks!  Thanks to Ben Bernanke's Quantitive Easing 2 (QE2) November 3rd announcement the risk asset party is in full swing again.

The Fed's planned purchase of $600 billion in Treasuries and QE1 rollovers over the next 8 months already has it fleeing into equities, commodities, and emerging markets -- before the QE even starts!
The elections put Congress out of the stimulus business.   Not to worry . . . .  The Fed's QE2 ship, captained by Mr. Bernanke, is launched and steaming off into dark, uncharted waters -- with or without congressional support.
Since the U.S. dollar is the world's reserve currency, you might say Mr. Bernanke is Captain of the World.  Worldwide FOREX, bond, equity and commodity markets all soar or fall on the slightest nuances from him.  To argue if it right for one man to have so much power is, at this point, moot.  He simply has it.
Who wins with QE?

• Banks:  They get liquidity and more time to repair their balance sheets.  The interest free money is reinvested where it earns more (rate arbitration -- profits come from the spread).  Why risk loans to the private sector when you get a risk free return from Uncle Sam?  According to Shahien Nasirpour in the Huffington Post U.S. banks own $1.6 trillion in taxpayer-backed assets such as Treasuries and Fannie and Freddie debt.
• Some of the public:  Rising markets benefit those who have the foresight be invested in them.  The hope, of course, is that inflating asset values will eventually spread to the increasingly desperate real estate sector.  No sign of that happening yet though.
• Corporations:  They are floating bond issues while interest rates are low -- get while the getting is good.  The stock market recognizes this and is rising.  High unemployment allows corporations to keep wages low and employees working on over drive.

Who loses with QE?

• Savers and other frugal people:  Interest rates are at record lows.  I didn't even bother listing the $2 interest income I made last year from a savings account.  The Fed is forcing us into risk assets and anyone who holds cash in U.S. dollars or cash equivalents such as treasuries loses.  If bond markets crack and interest rates skyrocket (as they will if inflation picks up) anyone holding fixed income denominated in U.S. dollars takes big losses.
• The U.S.:  Dollar devaluation sparks up commodity prices and exports inflation world-wide.  The recession stricken U.S., however, does not have the room to increase wages to compensate increasing fuel and food prices.  You already see the signs -- more people walking or bicycling (that may actually be good), more gardens, more roadside produce stands, empty malls, shuttered businesses, large numbers of homeless, etc.  The bottom line: One way or another, the U.S. standard of living is declining.

Other QE risks.

• Currency war:  QE in the U.S. raises all kinds of red flags abroad.  Both European and Japanese Central Banks may be forced to intervene (retaliate?), precipitating a "currency race to the bottom".  No wonder precious metals seem to be rising nonstop --  a certainty in a world of uncertainty.
• Capital outflows from the U.S.:   It flees to friendlier shores.  Badly needed domestic investment shrivels and the U.S. economy languishes.
• Never enough QE:  The $1.6 trillion QE1 did not revive the U.S. economy, so how will QE2's $600 billion?  Additional QEs will probably be implemented.  The Fed is independent and can buy whatever it wants, mortgage backed securities, bonds of all types, equities, you name it.  Eventually the U.S. will be forced to give up these futile attempts at stimulus; rates will go up and markets down as reality is faced.  The unfortunate fact is that QE has never worked in the long run.  Maybe this time will be different but don't bet on it.

Investment ramifications.

• Real assets:  Maybe stay with ETFs to avoid single issue risk. Precious metals (GLTR), agriculture (DBA), and energy companies (VDE) are but a few.  Click on the ETF tab on the Seeking Alpha website for additional ideas.
• Minimize fixed income investments (bonds): Upside risk is limited while the downside risk is infinite.  If you have safe treasury bonds and the incomes covers a fixed rate mortgage . . . maybe keep those -- some hedging is always a good strategy in times of uncertainity.
• Go with the trend:  As long as the Fed keeps its Zero Interest Rate Policy -- ZIRP-- you might consider some high dividend REITS such as Annaly Capital Management (NLY) and Chimera Investment (CIM) which benefit from ZIRP.  This is a risky area though as things can change quickly.
• Protection: You can protect yourself from rising interest rates with TBF and TBT but be aware of daily rebalancing erosion .

As always, do your own due diligence in picking investments.  Everyone's investment strategy and needs are different.  Only you can decide what is best for you.  This article only presents my thoughts on macro trends and is not a recomendation to buy or sell.   But, whatever you do, watch the bond market and Mr. Bernanke closely in the coming months and year.

Disclosure: Small positions in CIM and TBT