Has the Trend Turned Negative for Municipal Bonds?

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The state of Illinois's recentsettlement with the SEC for "misguiding" investors about its underfundedpension obligations, has brought municipal bonds back into the spotlight. 

Fraud is as old a risk as any,but there are now other concerns about muni bonds, some old, some new.

False Assumptions about Muni Defaults

Is the default rate of munibonds 0.6% or not?  Well, it depends onwho you ask.

If you ask the ratings agencies,they would agree with the 0.6% historical muni bond default rate.  Their data suggests that only 47municipalities defaulted between the years 1986 to 2011.  But this number is based solely on thosebonds the ratings agencies actually rate.

We also should keep in mindthese are the same ratings agencies now being sued for "misleading" what they reallyknew about the housing market in 2006.  Isit also possible some of the highly rated municipal bonds are actually riskierthan their ratings imply?  You betcha.   

What the Fed Said

If you ask the FederalReserve, they suggest the default rate is much higher.  Their 2012 report shows 2,366 defaults in thesame period.  This amount of defaults is only 50x more than the ratings agenciesimply.  To be fair, their sample size isalso a lot larger making the actual default rate assumption from the Fed more around4%. But even so, the Fed's data shows a 7x higher versus historical data published by the ratings agencies.

In an article titled, "Municipal Bond Defaults are Higher than Reported," we highlighted some of these very points. Why should we still care? 

Because, as we outlined in theETF Profit Strategy Newsletter released 7/20/12 when MUB was trading at $110, "Conservativeinvestors should avoid the munibond sector. For aggressive traders, a shorting opportunity will come, but only afterthe market technicals first confirm that it's time to do so".  By the way, the MUB is still trading aroundthat $110 price, and now the charts may bealigning with the negative fundamental outlook. 

What the Charts are Saying

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Over the longer-term, municipalbond rates remain near 50 year lows as the Federal Reserve chart shows. Butthis may be changing as cracks are starting to form in the foundation of the shorter-term.

In our ETF Technical Forecastprovided 3/10/13 we stated, "Keep an eye on the (MUB - News) and (HYD - News)indices as we have been talking about the coming disaster in muni bonds forawhile now, and these charts may be the first signs of a longer-term change intrend for munis.  A breakdown of MUB mayput that trade on the map."  In the chart below the iSharesS&P National Municipal Bond Fund is shown over the past 5 years and shows the recent weakness inMUB.

We also provided a short-term tradewith a Reward:Risk ratio of over 3:1 for HYD.   

The first thing to notice isthe previous declines of the index have not encroached into the price territoryof the previous peaks.  In 2008 munibonds sold off from the $87.5 level and then recovered making a new high at$99.  The ensuing pullback then heldabove $87.5 into 2011.  The next declineoccurred at the beginning of 2012.  Thispullback too did not reach the previous peak at $99.

The latest pullback, though,has now breached that $110 previous peak. This is coupled with declining momentum shown in the bottomsection.  None of the previous peaks wereassociated with such loss of momentum and this is a warning.

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The fundamental risks havebeen in place for awhile, now we are just waiting for the technicals to confirmthe top, which may indeed be occurring now.

The latest issue of the ETF Technical Forecast includesa focus on Municipal Bonds and price levels that can be used to short, placestops, and target for profits.  We use fundamental, technical, and sentiment data alongwith common sense to provide a unique perspective that goes beyond traditionalinvestment strategies.

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