California Muni Bonds - Is The Reward Worth The Risk? (Part 4)

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Every investment has its risks, and California municipal bonds certainly has its fair shares and some more. First and foremost, municipal bonds are fixed-income investments, and they are typically highly sensitive to interests rates. While we do not believe that normal interests rate fluctuation (in this distorted environment caused by the
bi-winning fed
anyway) will cause too much problems for municipal bonds since the Fed had already stated that it will keep interests rate artificially low, but also because of the wide spread between California muni bonds vs treasury bonds already. However, there are several scenarios which can cause interests rates surging and thus bring every fixed-income investment down with it. Some of them are: 1. Debt ceiling extension delay Almost every US government officials had now called delaying the raise of the debt ceiling was akin to playing with fire. But then of course, theories remain to be theories until they are proven correct, and Republicans are likely to use this chance to push as much as they can for their agenda. While most likely there will be some form of compromise to satisfy both parties, but in the case the worst case scenario plays out, i.e. interests rates soars due to some form of technical default of treasury bonds, municipal bonds, along with all other fixed-income instruments, will most certainly go down significantly. 2. End of QE II While most people believe that the bi-winning fed will be able to continue to keep interest rates low after ceding the QE2 program, there is no guarantee. However, even if interest rates rise in this case, we do not believe it will rise enough to cause too much problems for municipal bonds given the current high spread. 3. PIIGS crisis If Greece does default in the near term, it will almost certainly cause contagion in the other PIIGS countries. This is certainly not good news, but the effect on US interest rates might not be too bad as US treasures might become the safe haven, causing interest rates to drop even more. Nonetheless, investors might look at Greece, then look at all the states with high debt, and decide that the problems are similar, causing a surge in interest rates for the municipal bonds. 4. Other states start defaulting on their debt While we think California should do fine in the near term with its tax revenue and also cutting down expenses to get through its near term budget situation, we are not prepared to say this for other states. In the case some other states or their municipalities started defaulting in earnest, investors will certainly lump California with them together no matter how well California does. The worst case scenario will be that California municipals, seeing that other states are defaulting, decide to join the crowd to reduce their debt obligations. This would be the scenario that makes Ms. Meredith Whitney a genius again. Other than interests rates induced risks, one must not forget that most of the major California cities are locating on top of active earthquake fault lines. It is amazing to me many California real estate investors invest only in California real estates without ever thinking about diversifying geographically to mitigate the risks. In the case of a very severe earthquake, or more devastatingly, a series of severe earthquakes inflicting great damages to California cities, California is highly unlikely to be able to pay for the damages given its own financial problem, and US government would have to step in. Affected municipalities might be unable to raise new debts, and the California state budget, no matter how conservative, will be utterly destroyed. Of course, in such a devastating case, many insurance companies might also go bust, and many industries will get affected. Such a scenario may be unthinkable. But then, nature does not really care how we think. Aside from the aforementioned risks, readers should be aware that we do not think California has solved its long term structural problems, and thus we are only interested in more short term investments and trading opportunities in California municipal bonds. To read the previous articles on this topic, please visit the following links:
California Muni Bonds – Is The Reward Worth The Risk? (Part 1)
California Muni Bonds – Is The Reward Worth The Risk? (Part 2)
California Muni Bonds – Is The Reward Worth The Risk? (Part 3)
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Posted In: Long IdeasBondsDividendsDividendsTreasuriescalifornia municipal bondsdebt ceilingEarthquakeinsurance companies
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