Thursday, August 16, 2007

Illiquidity is hitting some strange parts of the bond market.

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.

No comments:

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.