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To plunge into municipal bonds – or not?
Posted By Christopher Grey On 12/27/2010 @ 8:24 pm In Commentary | Comments Disabled
It recently was reported that Bill Gross has bought a substantial amount of shares in several closed-end California municipal bond funds – even as shares in these funds have slid between 15 percent and 20 percent from their highs and many retail, as well as some institutional investors, are bailing.
Since this was done with his own money, he must disclose buying and selling these funds, and it appears to be at least $14 million of investments in Pimco California Municipal Income Fund II (PCK), Pimco California Municipal Income Fund III (PZC), Pimco California Municipal Income Fund (PCQ), Pimco Municipal Income Fund III (PMX), and Pimco Municipal Income Fund (PMF). I think this action is something that merits attention and some questions.
The biggest question, and the most obvious, is what does Bill Gross know that most other investors are missing about these funds and California municipal bonds? He clearly sees value in a place many investors see risk and potential downside. Most investors see a perfect storm hitting municipal bonds, particularly overly indebted places like California. The perfect storm includes an extension of lower taxes, an imbalance between issuance in 2011 and demand, the end of the Build America Bonds subsidy, a Republican Congress opposed to more bailouts, and state and local government saddled with impossibly high employee pension costs.
Since there is possibly no better long-term, or short-term, bond investor than Bill Gross, his contrary view of this sector deserves attention.
One thing Gross may know, or possibly just guess at, that other investors are missing is that there are many much easier and less painful ways for California municipal issuers to meet their debt obligations before they would try to negotiate concessions from bondholders.
Another possibility is that with his political connections, he knows that the government will provide further bailouts to make sure bond investors are protected. He could also be betting on a recovery in tax receipts resulting from an economic improvement. One more possibility often overlooked, because it hasn’t happened, is that state and local government might finally get serious about cutting costs, including pension costs.
Like the private sector unions in the 1980s and 1990s, public unions and their benefits have finally hit a wall. The states and cities simply can no longer afford to pay these costs. It is either cut employment, salaries, and benefits or face insolvency. There is no possible way for any of these states or cities to raise taxes in a way that will fix their budget problems and they know it. Cost cuts, very deep and lasting cost cuts, are the only solution. These cost reductions would dramatically improve the ability of states and cities to repay their debts, thereby increasing their credit quality.
Current spreads between high quality (A rated or higher) municipal bonds and Treasuries of similarly high quality corporate bonds would indicate that the municipals, especially for taxable investors, are severely undervalued unless there are going to be a wave of ratings downgrades in the near future. Bill Gross is betting that between cost cuts, bailouts, and economic improvement, downgrades in the municipal sector will not be nearly as bad as many investors fear.
When an extremely sophisticated and successful investor like Gross goes against the herd, it’s worth paying attention to. I’ve bought a small amount of the same funds he purchased at slightly higher prices. This is partly for diversification because I don’t currently own any bonds, and these seem to be better than other bond alternatives right now, partly because I don’t like ordinary income and these funds offer tax-free yields in the 8 percent to 9 percent range, and partly because I think Gross may know what he is doing here. If not, at least I have good company.
Disclosure: I am long PCK, PZC, PCQ, PMF.
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