PIMCO’s Narens on the Muni Bond Trade, Part I: —Is it Time?

At the local level, on the other hand, defaults should become more common.  Reasons:

·       Less state aid (see above).

·       Ongoing housing crisis leads to lower property tax revenues.

·       Less liquidity/higher spreads in local munis.

Significant long-term risk: Unfunded pensions

·       Unfunded pension liability estimates range from $700 billion to $3 trillion, depending on discounting methods.

·       In some states, full depletion could lead to "pay-as-you-go" costs of up to 40% of state budgets within the next decade…Obviously not sustainable.

2. Municipal Bond Fund Outlook

PIMCOhas had huge outflows from muni funds of late, but insurers and other large players are moving in.

Even some non-tax-exempt "cross-overs" like hedge funds are moving into the space because muni spreads are so high.

PIMCO is not expecting a muni supply spike, for two main reasons:

·       Much of the debt issued in favorable circumstances last year was intended to fund projects this year.

·       Many projects will be canceled because of high interest rates.

Because of near-term risk, PIMCO has shortened duration in its muni funds.  ("Safe spread" per Bill Gross's terminology.)  Still, PIMCO considers the risk of default, even in troubled states, to be low – much lower than is currently priced into the market.

3. The Rest of the Story

Even balanced-budget states can have projected "deficits" because of intra-cycle changes to revenues.  Deficits are forecasted in the absence of fiscal adjustments.

A federal proposal to allow bankruptcies by states caught the markets by surprise, but it probably has no traction.

Individual muni issues cannot be shorted by law, but CDS can be used as a hedge.  Nonetheless, PIMCO is not concerned about the possibility of hedge funds "ganging up" against muni bonds.

PIMCO does not hedge within muni funds.  Risk is managed through bottoms-up credit analysis and shortening of duration.

Risk points for individual cities: Secular decline (e.g., Detroit), poor financial engineering (e.g., Jefferson County, Ala,), funding for non-viable projects (e.g., Harrisburg, Penn.).