"Municipal Bond Funds: Bleak Future" (BFZ)

From Elliot Wave:

High-risk bonds compensate investors by paying higher yields than low-risk bonds. But because of the tax-free status of municipal bonds, presently municipals pay higher after-tax yields than Treasuries do. So,although many municipal bond investors believe they are being conservative by investing in tax-exempt muni debt, they actually buy municipal debt because it carries more yield than Treasuries.

This reach for yield will likely come back to bite muni investors once state finances are caught in the teeth of the next bear wave. But with interest rates near zero, can you blame investors for reaching for extra yield? Munis and muni bond funds have also been popular due to: 1) The belief that higher tax rates may be needed to pay for the government deficits, and 2) The high distributions muni bond funds pay.

Many investors are blissfully unaware of the fact that many muni funds use leverage to pay high distributions. This added layer of risk makes these funds subject to the same liquidity concerns that plague other risky assets -- and as such, many muni bond funds act similarly to stocks. This highlights Elliott Wave International’s “All The Same Market” idea once again. (In Ch. 21 of his 2002 Conquer the Crash EWI's president Robert Prechter observed an unusual correlation between the S&P, gold, silver and the CRB and postulated that those normally disparate markets moved together "as liquidity expands and contracts.” A May 2004 Barron’s article by Prechter and Kendall added junk bonds, real estate, small-cap stocks, hedge funds and emerging markets to that list -- hence, "all the same market.")

From an Elliott wave perspective, this chart of the Blackrock California Municipal Income Trust (BFZ) has two points that suggest trouble ahead for it others like it.

• Dramatic fall. If you know Elliott, you can see that an impulse wave unfolded from April 2007 until December 2008. After topping before stocks in late 2006-2007, many similar funds fell as hard or even harder than the 60% drop seen here in BFZ. California isn’t alone as Pimco’s NY Muni Fund (PYN) and Van Kampen Ohio Quality Municipal Trust (VOQ) show that many muni funds trade together regardless of the issuer or manager.
• Corrective rally.Again, experienced Elliotticians among our readers will notice that BFZ has rallied in three waves from its December 2008 bottom, which puts it into the Fibonacci .618 resistance area. As the stock market rallied in 2010, BFZ has been unable to follow. Based on this fund and others, it looks like California’s muni bonds may lead to the downside, just like they did in 2007.

This forecast stands in stark contrast to the rating agencies’ opinions. Not one state carries a non-investment grade rating, and California alone occupies the level just above junk. But it's not that surprising, as these are the same agencies that were oblivious to the real estate bubble.

The February 2009 issue of our Elliott Wave Financial Forecast stated, “The degree of the [down]turn suggests that muni-bond defaults will surpass the 30% rate of the 1930s.” California had to issue IOUs in order to avoid default in 2009. Let’s see how the other 49 fare this year.