<p>10 yr U of M bond is trading at a huge premium relative to what I consider the financial soundness of the university should imply (primarily due to the stretching for yield that's going on everywhere caused by QE-infinity). The 10 yrs (taxable-version) are currently yielding 300 bps, for an OAS of about 100bps. </p>
<p>I think U of M bonds are good SHORTS at these levels for the following reasons:</p>
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<li><p>In general short rates is a good bet given the historical low rates. Obviously you could have said that for the past 2 years but Fed possibly tapering QE in the foreseeable future is a real catalyst for rates to normalize towards historical range. </p></li>
<li><p>While U of M is financially sound, it's pretty ridiculous to be yielding 15bps north of apple bonds of similar tenor, a company that's sitting on 100B cash with no prior liability, or 50bps north of agencies of similar tenor, with implied government guarantees. Let's ignore financials for a second and assume the university of michigan is as financially sound as a company like AAPL or GE (which is a very generous and unrealistic assumptions if you look at the financials of U of M like how you would scrutinize a private company), just the political risk associated with a public institution alone should be compensated by more than the 15bps spread to these highest quality cash cows. In addition to the idiosyncratic piece that i feel is very mispriced, as rates normalizes and the thirst for yield subsides, spreads should widen at least a bit as well; again, macro tailwind.</p></li>
<li><p>Comparing that to state of michigan bond (taxable version) of the similar tenor, the university of michigan bond is trading about 50bps rich in terms of spreads. Maybe that makes sense in normal times, maybe not. I don't have time to dive into the financials. However, this is what I know: if the state of michigan financials become distressed, so will U of M. For one, it is questionable but not out of the realm of possibility that the state can liquidate U of M's asset if they need to (similar token to the story about detroit thinking about liquidating the institute of art's exhibits), and even if not voluntarily, I am sure that's the first place the creditors will look, given the size of the michigan endowment. Let's consider the less extreme, if the state cut its appropriation to michigan in half, that alone should be cause for a drop of at least 3-4 levels of implied rating given the revenue hit.
While unlike detroit, the state of michigan financials actually look pretty healthy, municipal financial stability changes on a dime, given the elasticity of tax receipt relative to macro environment.
For this reason, I think it makes absolutely no sense that U of M bonds yield substantially less than state of michigan bonds. That's similar to the bonds of a wholly owned subsidiary with no collateral guarantees trading richer than that of the parent (ignoring capital structure/seniority/tranches/liquidity).</p></li>
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<ol>
<li>While I generally hate trades that are negative carry, the carry cost of this trade is just really cheap given the low rate environment. Well worth it given the potential catalyst in addition to all the tail wind.</li>
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<p>For the above reasons, i believe university of michigan bonds are a good short, whether it be in a relative value or even as a stand alone outright short. Really a low downside, pretty juicy upside type of trade with substantial macro tail wind.</p>
<p>Obligatory disclaimer: The above represents a personal opinion, and in no way represent the view of the fund I work for. In addition, the above DOES NOT constitute actionable investment advice, just some off the head type of thoughts (I have spent about 10 minutes on this thesis :p)</p>