Wednesday, August 15, 2007

Retail is easily freightened, but they will soon be back

Illiquidity is hitting some strange parts of the bond market. Consider one place about as far from sub-prime MBS as possible: municipal bond funds. The graphic below is the average premium (negative being a discount) on closed-end municipal funds.

For anyone who doesn't know, a closed-end fund is just like an open end mutual fund, except that the number of shares are fixed. Closed-end funds trade on exchanges just like stocks. Therefore if you want to buy into the fund, you have to find someone to sell to you. Therefore its possible (and in fact almost always the case) that the fund trades at a price significantly different from its net asset value. If the fund has a 5% premium, that means that you have to pay 105% of the net-asset value of the fund. More commonly, closed-end funds trade at a discount. Why that is the case is a debate for another time.

I track the premium on muni funds as an indicator of retail demand. Since there aren't a lot of new closed-end funds being created, the movement of the premium is entirely due to demand for the funds. And because retail are the primary investors in closed-end funds, its a good indicator.

Generally the premium has a strong seasonal element. Retail tends to have cash needs around tax time and around year-end. So closed-end funds tend to fade a bit during these periods. You can see this on the graph. But the sudden swoon starting at the end of June is highly unusual. Why have muni investors been dumping their closed-end funds?

I have an interesting theory: deleveraging. Let's say that I'm a high-net worth individual worth around $10 million. So I've got some closed-end funds and some regular municipals with my broker. But I also invested in this cool hedge fund my broker told me about. It is very exclusive and I loved talking about it at the club. I didn't really understand what it was invested in, but it had to do with mortgages and leverage. Anyway, its returns were great... until suddenly I got a letter saying withdrawals have been suspended. Now I need to make a margin call because that New Century stock I bought isn't working out too great. What am I going to sell?

When almost everything you own is performing like shit, and you get a margin call, you become forced to sell something. Invariably people sell something that is doing OK. We're seeing this in the institutional market, and I think the closed-end funds are telling us this is happening in the retail market as well.

By the way, if you think plain vanilla muni closed-end funds are performing poorly, try high-yield funds! Some of that stuff is down 40-50%, and I'm not talking about MBS-related funds either. There is panic on Main Street as well as Wall Street!

Fair Disclosure: I own some closed-end funds personally. Please bear in mind that closed-end funds are far more volatile than they should logically be and trading volume is often very thin. Do not get involved unless you understand the consequences of these two factors.


dond said...

On 4/10/07 the muni index I follow, Nuveen Municipal Closed End ETF Price Index took the largest hit I could find on the chart and then trended down, down, down. What the hell happened in that market on 4/10? I have no clue.


Anonymous said...

Sorry if OT, but could anyone explain what this chart is indicating?

Federal Funds Target Divergence

Thanks in advance.

Anonymous said...

Sorry, if it got cut's a shorter link

mOOm said...

There are funds that trade closed-ends based on reversion to mean of the premium e,g. TFSMX. These funds are being hit in the quant hedge fund train wreck

Anonymous said...

Please explain in minute detail how a rate cut affects the bond market.. because the only thing I see a rate cut doing is building another bubble by pushing the problem forward another 5 years - and making it another ten times worse than the current one.

Bernanke's job is to keep inflation from rising, not to bail out insolvent companies that made bad investment decisions.

Anonymous said...

Federal Funds Target Divergence

The chart shows that there has been a de facto easing. The target rate is still 5.25% but, shall we say, the tolerance for differences between the target and the actual rate has been increased.

The source data shows some fascinating daily lows.

Superbear said...

The fed can't lower the rates now because the $ will be run over. So, they have to keep the rates where they are and will probably let Countrywide, Thornburg Mortgage and maybe a few banks fail.

My guess - we'll be in recession by the end of the year, markets would have crashed by October (probably a global market meltdown) resulting in flight to quality and propping of US $ which will allow the Fed to cut the interest rates. In the meantime, the Fed will be pumping enough money in the system via open market operations to prop banks.

As far as the markets are concerned, we may see a short-term pop in the market where S&P goes up to 1450 only to experience sharp decline. If it goes up to 1450, be ready to shoot the bulls.

After the market went down today, there was a rumor that the Fed is planning to have an emergency meeting to cut interest rates. These rumors have been circulating in the market since last Thursday - it is possible that some bulls might be trying to spread it to lift the markets and get out of their positions at higher price.

Bill Poole of Dallas Fed came out 5 hours ago and squashed the rumor saying that he doesn't see a need for the rate cut since the larger economy isn't affected yet.

However, it is possible that Fed, in its infinitely small wisdom, may decide to cut rates. Even in such a case, the market may show a temporary pop - only to resume its decline. The reason is that the current turmoil is caused by credit crunch, i.e., unwillingness (NOT inability) of the lenders to fund risky propositions. That risk-aversion won't go away that easily if the lenders feel that they will lose money by lending to CFC and TMA. So, the rate cuts won't change a damn thing. On the contrary, it will make foreign lenders dump their mortgage security holdings (due to $ depreciation and fear of further value erosion) - and will increase long-end of the curve. In short, mortgage rates will go up even further, exacerbating the situation.

So, if you hear Chairman Bernanke warming his helicopters for the $ drop (google - Helicopter Ben), be sure that there will be many currency speculators ready with their bazookas to shoot those dollars - aka - a we'll see a run on the dollar.

Accrued Interest said...

Dond: That particular move might have been tax time.

As far as the FF deviance, the Fed has in fact cut their target rate to 5%. There is no other explanation for the trades going on in FF. Now maybe this stealth cut will only last a few days, but I'm telling you, the Fed has cut.

Anonymous said...

Hi, great blog!
what's your view on CIT Group Inc?
Why has its CDS widened out by so much? is likelihood of default very high?

Anonymous said...

the Fed has in fact cut their target rate to 5%.

Very good call on your part.

Thanks for a great financial blog.

I was particularly impressed with the restraint you showed Tues, 14 Aug in your responses to comments.

I am grateful, and relieved, that your flow5 policy has changed from
Also, Flow5 needs to start his own blog.[29 July]
Flow 5 is like my guest blogger. [10 Aug]

Your blog has intellect and character.

Accrued Interest said...


Thanks for the kind words. I'm trying hard to keep every thing civil here. I don't mind having my arguements ripped as long as it stays civil.

And I always liked Flow 5's comments. He's just very voluminous! I said he should start his own blog because his stuff is worthy of more attention. Flow if you are reading, thanks for being part of our little community.

Accrued Interest said...

On CIT: I don't follow the company that closely. They widened substially immediately after the SLM LBO. Remember that the theory behind the SLM deal was that they could afford large leverage because they could securitize their loans. CIT could theoretically do the same thing, although in today's maket I doubt it.