The states are in trouble and the water is beginning to flow over the dam. On Monday, the Governator - Arnold Schwarzenegger, declared a fiscal emergency in California claiming that the state could run out of money by February. As well, the National Conference of State Legislatures (NCSL) and National Governors Association (NGA) released a letter pleading for the Congress to pass a stimulus package. The NCSL reported that 30 states have shortfalls totaling $30 billion, while California already has a budget gap of $11 billion. Interestingly, municipal bond yields have not responded to these developments and that represents a juicy opportunity for investors.
Currently, 30 year Aaa bonds are yielding 5.6%%, while 30 year Baa bonds are yielding above 9%. In contrast, 30 year Aaa municipal bonds are yielding 5.3%. An historical look at Aaa and Baa corporate bonds reveals that the yields are near all time highs.
Furthermore, GE (GE) was re-affirmed as a Aaa credit rating today even though it announced weaker than expected earnings. The key of course is the earnings part, they still have some. However, California and 30 other states have an "earnings" shortfall.
If we look at the municipal bond yield curve for Aaa general obligation bonds, it is clear that the yields have not changed dramatically over the last six months, while economic conditions have deteriorated. In fact, the unemployment rate for the US as a whole is at the highest level in over 8 years.
Two of the most populous states and economically important are California and New York. Over the last year the unemployment rate in California has risen to all time highs. It is not difficult to deduce that the higher unemployment rate means people spend less and fewer taxes are collected. Throw in a legislative reluctance to raise taxes and voila, an economic crisis.
Great charts, but how do we make money from this?
The simple answer is to short municipal bonds and the easiest way to do that is to sell short the iShares National Municipal Bond ETF (MUB). This etf invests in primarily Aaa rated municipal bonds and over 30% of the portfolio is concentrated in issues from California and New York.
While investors have been running into the US government bond market they have ignored the municipal bond market and its inherent weakness. Once the market realizes that these Aaa rated muni bonds are less safe than both Aaa and Baa corporate bonds then the yield should increase while price decreases to reflect the new risk premium.
Disclosure: I am short MUB