Monday, January 24, 2011

Another Lesson In Contrarian Investing

Let me start this post by saying that I have shown myself to be, at least temporarily, very wrong on the subject of pricing in the municipal bond market. Having made a series of investments in mid-November, I am eating my words on the my original belief that I could make a quick profit. It now turns out it will take a little longer.

My original thesis was that the default risk for municipalities does not support the current prices. In December, a well known financial analyst named Meredith Whitney appeared on CBS's 60 minutes. The piece was entitled a State Budgets: The Day of Reckoning. In it she hypothesizes that hundreds of billions worth of municipal bonds will default in the near future. More knowledgeable investors who specialize in the bond market have stated that she is wildly overestimating the potential problem. Bill Gross, the legendary self-made billionaire bond investor, has been a buyer in the market as well as a critic of Whitney's analysis. The short explanation goes like this: municipalities (broadly defined as governments and gov. agencies other than states and federal gov) are facing lowered revenues (less property taxes, fees, etc) and increased costs (primarily benefits for employees), and many will have to restructure their existing debt because they can't make the payments.

In short, I agree that municipal debt issuers are in a rough place, however, it isn't that bad. Revenues can be adjusted upward as most issuers are normally monopolies (anyone ever call around to fire departments to get better pricing during a car accident/house fire?) and the defined benefits scheme which is now plaguing governments everywhere is going through a generational shift. I fundamentally believe a general obligation bond with a good credit rating (AAA/AA) is not priced correctly right now.

The difficult part remains investing while avoiding the avalanche of selling. Most investors don't do their own research and tend to be late to the party (selling or buying), so the question is how much longer they continue to push prices down. I'll keep my investment and lower the cost basis, but this will certainly take a while to work out. I really wish that I had the ability to buy individual bonds, I would be able to cherry pick. A few more million yet to go.