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F*%k You. Pay Me.

There is a great scene in Martin Scorsese’s 1990 masterpiece Goodfellas that perfectly describes the municipal bond market.

The set up is this:

A restaurant owner is having some problems and comes to local mob boss Paulie Cicero (portrayed masterfully by Paul Sorvino) for help.  Cicero in turn becomes his partner to help alleviate his pain.  The restauranteur now owes Paulie big time and Paulie doesn’t care what the problems are, he wants his money.  Henry Hill (played by Ray Liotta) works for Paulie and describes the issue like this:

“Now the guy’s got Paulie as a partner.  Any problems…he goes to Paulie.  Trouble with a bill…he can go to Paulie.  Trouble with the cops, deliveries, Tommy…he can call Paulie.

But now the guy’s gotta come up with Paulie’s money every week…no matter what.

Business bad? F*%k you. Pay me.

Oh, you had a fire? F*%k you. Pay me.

Place got hit by lightning?  F*%k you.  Pay me.”


Here is the scene in case you want to watch It…it’s brilliant.




 
Municipal bonds got absolutely hammered last week in a selloff of almost Biblical proportions.  Anything that wasn’t nailed to the ground was sold.  GO bonds, revenue bonds, high quality bonds, low quality bonds, short duration, long duration…they all got thrown out along with the kitchen sink.  If you’ve been reading this blog for a while, then you know that I’ve been saying for the past couple of months that I thought bonds were overvalued. I’ve been advocating for clients selling long-dated bonds (which were at historically low yields) and buying high quality, short duration bonds to soften the blow from a pickup in rates and an inevitable wave of downgrades in the BBB space.

Then munis sold off by 15% in a little more than a week. That's insane...I didn’t think they were that overvalued.

The move was swift and brutal. A lot of bonds simply weren’t getting bids as it was really a liquidity issue more so than a credit issue (there are some isolated concerns in the credit space…I’ll get to that) and so pricing services were forced to take their best guess at what that stuff was worth.  The prices were all over the place but had one thing in common…they were a lot lower. 

I started my career working for the smartest person I’ve ever met when it comes to munis… the one and only Jeff Horn.  The man has forgotten more about the muni market than I will ever know.  A lot of people turn to me for advice on munis but the truth is I learned everything I know about the market from Jeff.  My first day on the job, he gave me the best piece of advice I’ve ever gotten when it comes to munis:

“There are two kinds of bonds in the world: bonds that pay and bonds that don’t pay.  Buy the ones that pay.”

Simple, actionable advice. Ever since then, I’ve been buying bonds that pay.

So that leads us back to Uncle Paulie...

He’s a first lean creditor (of the mafia kind!) on the restaurant. He gets paid first no matter who, what, when, why, or how things went wrong.

Slowdown in business? Fire? Lightning? F*%k you. Pay me.

High quality munis are for the Uncle Paulie in all of us. 

Consider California general obligation bonds. The state is constitutionally barred from declaring bankruptcy and bondholders are considered junior only to education costs. The state can’t pay wages without paying bondholders first. The state can’t pay rent without paying bondholders first. The state can’t close the pension funding gap without, you guessed it, paying bondholders first.

Capital gains tax revenue down because the market sold off?  F*%k you.  Pay me.

User fees from parks and beaches down because everyone is staying inside? F*%k you. Pay me.

Healthcare costs now going up and being covered by the state?  F*%k you.  Pay me.


That’s what makes this past week’s market action all the more strange. It took down high quality, normally liquid credits like California GO’s just the same as it did more speculative and smaller deals. It was widespread, chaotic, and unprecedented in scope. But that doesn’t mean that high quality bonds won’t pay; they can weather a lot more than what the market threw at us this past week and will absolutely continue to pay.

That's why I believe last week's selloff created some opportunities in the space, particularly in the type of names that I've been advocating for.  You can now buy AAA rated bonds due inside of one year at yields north of 2.50%.  To give you a little perspective, those same names were trading well below 1% just a couple of weeks ago...that's a big move in a short period of time.  Put cash to work in these names, some of which are pre-refunded and, thus, collateralized by Treasuries.

But are there now credit concerns in the muni market?  Maybe a few.  Take Anaheim for example…

Anaheim receives a disproportionate share of its tax revenue from Disney as a result of Disneyland being located within the city limits. Disneyland employs 30,000 people in the city, accounts for a few thousand hotel rooms on any given night, and provides the lion’s share of the city’s restaurant traffic on any given weekend. All of those things generate close to $200 million in direct tax receipts each year (approximately 45% of the city’s general fund revenues), some of which is used to pay interest on their bonds.

So what is the effect of Disneyland’s recent closure on Anaheim? No one knows because it’s never happened before, but we know it isn’t good. How long could the closure last? No one know because it’s never happened before, but we know it's longer than bondholders want…

Now, Anaheim is probably a bit of an extreme case. Just like most other markets though, munis are now being repriced by the seismic shift that’s taken place as a result of coronavirus… and, like most markets, we’re still not sure what that means just yet. The markets need to adjust to this "new normal" and price in all of this information as it becomes available...that takes time.

One thing we do know for sure is that when investors get spooked, they tend to shoot first and ask questions later. When liquidity is needed, they usually go to their most stable assets first since they think they know what they will be worth in a fire sale.  The combination of those two things is the easiest explanation for what happened to munis last week. 
 
 Having stocks sell off in a rapid fashion is one thing but seeing bonds do it is an entirely different one.  The Federal Reserve recognized this and stepped in over the course of the past week to both stabilize prices and ensure smooth functioning in credit markets.  We’ll have to have to take a wait and see approach as to whether their actions worked but early indications are that they were successful.  As time goes on, we should see the relative cheapness of munis subside and normalcy will return to the market.

In the meantime, however, try to channel your inner Uncle Paulie and buy some high quality, short duration munis at cheaper prices than we've seen in quite a while…

It's an offer you can't refuse.