Some munibond funds are right now yielding 5%-6% tax free. A 5% tax-free yield translates to 7% pre-tax yield (assuming 30% tax rate). Look at some Blackrock funds (MQY). Why is this the case?
Normally municipal bonds are the safest bonds around. Their default rates have been amongst the lowest. With Fed fund rate at 3%, muni funds should not be offering 5%.
It is not that suddenly muni bonds have started defaulting which has resulted in this spread widening. Rather some interesting events have happened in the muni market:
(a) Threat of monoline downgrades - If MBI or Ambac lose their AAA rating, muni bonds insured by them might also lose their AAA rating, if the rating of the issuer is below AAA.
(b) If (a) happens, some muni funds will dump the downgraded securities, per their guidelines on holding non AAA securities. If the funds are forced to dump in an illiquid market, the prices realized might be lower than used in calculating NAVs.
(c) Failure of Auction-rate preferreds auctions: Muni funds have historically used leverage to juice up their dividends to common shareholders. The mechanism they used to lever up is called auction rate preferred shares (ARPS), which has failed in the last 2 weeks. It is essentially like an SIV - use short term funding to buy long term assets and profit from the spread. The risk is that one needs continuous access to short-term funding to rollforward the debt as it comes due. I guess ARPS investors have gone on strike much like SIV investors, because they fear that the collateral backing the securities has lower value (or will have a lower value if monolines get downgraded and the muni fund is forced to sell the downgraded bonds in an illiquid market). More can be read on the Blackrock site - http://www1.blackrock.com/eIndex.aspx?eid=43598&cmty=ind&ln=36494&lo=4
Is there a parallel between SIV fiasco and the unfolding ARPS fiasco? Muni bonds are much safer than subprime mortgages. Besides ARPS are overcollaterized - a muni fund needs to back ARPS by 200% of collateral. I dont know about SIV's - but I dont think they were as collaterized. Still, investor confidence has been shaken in ARPS, and confidence is the currency of the realm. If investors dont return to the ARPS market, muni funds might be forced to redeem their ARPS by selling some assets (deleveraging) in today's illiquid market. That will hurt common shareholders.
The key then - is to figure out the conditions unders which ARPS holders can force the funds to redeem their securities. If the funds can postpone the redemption indefinitely, they can wait for 1-2-10 years that it takes market to return back to normal and then redeem at fundamentally justified prices. In this case, common shareholders like me benefit. If, on the other hand, the funds are forced to redeem after - say x days - then if the ARPS credit crunch continues beyond those x days, I as common shareholder might lose.
Or, one just needs to believe that whatever happens, regulators will ensure that the municipal business of the bond insurers continues to get the AAA rating. Spitzer said on Thursday that bond insurers have 3-5 days to figure out a private market solution. That makes the deadline today. If the threat of mass downgrades on muni bond goes away, I think ARPS market will snap back to normal over time. And that will make muni funds attractive. I am willing to take that bet.