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Thursday, March 10, 2011 12:06 PM

State of Denial on Municipal Bonds; Are Munis the New Subprime?

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Municipal bonds show signs of trouble despite the stock market's rally says Jeffrey Gundlach, DoubleLine Capital CEO in a CNBC interview regarding the Muni Bond Market.

Bond king Jeff Gundlach likened municipal bonds to subprime mortgage bonds on CNBC’s Strategy Session on Wednesday.

“You’ve got a history of low defaults, which is comforting. But that kind of sounds like what subprime sounded like back in 2006,” Gundlach said.

Gundlach said the markets for subprime bonds and municipal bonds are similar because the buyers are similar. Muni bond buyers aren’t seeking fundamentally good credit stories—they are buying for “technical reasons,” Gundlach said. This is exactly what happened with subprime

With subprime bonds, buyers were seeking highly-rated credit with very low default histories in order to satisfy regulatory bank capital requirements. They largely ignored deteriorating fundamentals, and continued to buy subprime mortgage-backed securities at a rapid clip even when the problems with the market were becoming apparent in the first half of 2007.

Muni bonds are bought for a different “technical reason”—the tax benefit—and buyers are once again ignoring deteriorating fundamentals. So are munis going the way of subprime?

“If by that you mean, lower, then yes. If you mean crashing, I’m agnostic on that,” he told David Faber.

Gundlach pointed out that even if defaults do not ultimately climb as high as critics like Meredith Whitney have warned, muni bonds will likely trade much lower.

“Between here and the end game, lies the valley. And the valley is full of fear. I think the muni market is going to go down by at least, on the long end, something like 15 and 20 percent,” he said.

I like his rationale. It's not so much the volume of munis that may default, but rather the market's likely reaction when those defaults do happen.

It's a good interview. If you are interested in munis, please play it.

Better buying opportunities await those willing to sit in cash, not just in munis, but in equities, junk bonds, emerging markets, and commodities.

Mike "Mish" Shedlock
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