How to Make a Puny from a Muni

In September 2010, Meredith Whitney produced a 600-page report, which, she believed indicated that 50 to 100 sizable municipal bonds would likely default in 2011. Whitney, who made her name covering bank stocks, was credible. The market responded.

Between September 30, 2010 and February 22, 2011, price per share dropped in the muni fund market, not just in the longer term, but the shorter as well. For example, between September 30, 2010 and February 22, 2011, Vanguard Short-Term Tax-Exempt Fund (VWSTX) went from 15.80 to 15.75, a loss of 0.32% of its value. Nuveen Barclays Capital Short Term Municipal Bond ETF (SHM) dropped from 24.10 to 23.69, down 1.70%. The maturity of the former is 1.30 years and the latter about three.

Since SHM has longer term bonds in its portfolio, this may have contributed to its greater drop. Another alternative is that mutual funds such as VWSTX can’t be traded during the day like SHM and this may have spared it some sales.

So, by February, we have a puny muni.

“Wait a second,” say bond specialists more seasoned in this area than Whitney. PIMCO put out a report in Feb. 2011 that challenged her. The authors, Christian Stracke, global head of Pimco’s credit research group, and Joseph Narens, a municipal credit analyst for the firm, projected that local municipal issuers would implement ways to side step default. Some of the methods they suggested included spending cuts plus an increase in property tax. We were already seeing the former and the latter were in the works.

Alexandra Lebenthal from the Alexandra & James, a company that specializes in tax-free municipal bonds, took issue with Whitney as well.

The question back in February was, “What to do?”  If investors believed Whitney they would flee municipals as many already had. If they had trust in muni bond specialists, they would be less likely to take flight (Whitney was not a municipal bond specialist). Of course, some could say that the vested interest of muni managers might make them more likely to promote them and thereby their take might be biased.

Whatever the case, it was the investors who sat tight that made money. Between February 22, 2011 and November 14, 2011, short-term municipal funds gained in value. VWSTX increased from 15.75 to 15.90, approximately three times the earlier loss. SHM similarly gained from 23.69 to 24.24, about two times the prior loss.

The Whitney story and some investor’s initial reaction to it, to sell municipals parallels Warren Buffet quote:  “I violated the Noah rule: Predicting rain doesn't count; building arks does.

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