Buy Side

Forced Selling Sets Odd Stage in Muniland

The forced selling plaguing municipal bonds has distorted some segments of the market into bizarre contortions.

Three peculiarities in particular - prerefunded bonds yielding higher rates than the Treasuries backing them, corporate-backed munis trading at higher rates than the bonds of the corporations backing them, and higher relative yields on insured bonds implying that insurance detracts from the likelihood of repayment - are anomalies with no plausible explanation other than more people selling than buying.

"Logic is out the window when market forces take over and forced selling comes in," said Terry O'Grady, senior vice president of municipal trading at FMSbonds.com, a muni boutique based in Florida. These idiosyncrasies go beyond stretching historical relationships or foiling ratios previously taken for granted.

The deleveraging of the entire financial system has turned many investors into unwilling sellers, according to O'Grady.

While more retail investors have been beckoned into the market, there are not enough of them to meet the supply from the sellers, he said.

"The smartest guys in the room are the guys that are behaving like the dumbest people in the room," O'Grady said. "None of the institutions want to be selling the bonds they're selling at these levels. It's got to pain these money managers to be liquidating these bonds into these markets."

Meanwhile, O'Grady said this is a "historic buying opportunity in municipals."

TREASURIES ON THE CHEAP With Treasury bonds on a stunning run - the three-month bill last week carried a negative interest rate - many investors probably wish they had bought Treasuries when they were cheaper. Because of a quirk in the muni market, they still can. The answer: prerefunded munis. A prerefunded muni is a state or local government bond slated to be repurchased from the bondholder at a future date.

In the meantime, the issuer buys Treasuries maturing when the bonds are scheduled to be repurchased. The Treasuries are placed in the refunding escrow and support the coupon payments on the munis, effectively allowing the government to refinance its debt.

The upshot is the bond's coupons are secured by the Treasury's credit, funneled through a municipality's tax-exempt interest payments.

The market has historically attached rich value to tax-exempt interest payments supported by the most creditworthy borrower in the world.

Since the turn of the century, five-year prerefunded munis have usually yielded less than 90% of five-year Treasuries, according to Municipal Market Data. They have often traded at less than 80%.

In 2007, yields on five-year prerefunded munis matched the yields on their counterpart Treasuries for the first time. This summer, the yields spiked. They now yield more than 170% of five-year Treasuries.

By buying a prerefunded muni, an investor can collect tax-free interest payments backed by the Treasury at a higher rate than the Treasury's own taxable rates.

The counterpoint defies explanation.

Prerefunded munis were decent deals even when their yields were lower than their corresponding Treasuries' yields, said Daniel Lennon, manager of the GMS Group's main branch in Livingston, N.J.

With these yields, he said prerefunded munis are "an absolute gift."

"It's basically an inefficiency in the market that smart buyers are taking advantage of," he said.

Lennon said there is an "active, liquid" market for prerefunded bonds, though it is a little tighter than for more mainstream munis. Good brokers can find prerefunded munis for clients, he said.

WORSE THAN WORTHLESS Another anomaly is the insurance discount. The market has judged that insurance from a previously triple-A rated insurer is somehow worse than worthless. As the ratings agencies began downgrading bond insurers this year, the market began to assign less of a premium for insurance.

Insured bonds historically carried lower interest rates because monoline coverage presumably moderated the risk of nonpayment. When the credit crisis came to a boil, though, the diminishing premium turned into a discount.

In many cases - California and Puerto Rico are among the exceptions - MMD's yield curves show insured bonds carrying higher interest rates than uninsured bonds of the same maturity and credit quality.

Even in a worst-case scenario, insurance could not possibly detract from an issuer's ability to repay its debt.

"The market isn't being very rational right now," said George Friedlander, managing director and fixed-income strategist at Citi. He said some funds have tried so hard to avoid the "taint" of certain weak insurers that they are willing to pay more for uninsured bonds.

For example, a 10-year Massachusetts general obligation bond on Thursday yielded 4.43%. An insured bond of the same maturity issued by the same state yielded 4.62%. A year and a half ago, the MMD insured curve was three basis points less. Similarly, whereas insurance in June 2007, before the credit crunch began, lopped five basis points off the yield on a 10-year New York GO bond, insurance now adds five basis points.

"Some investors just don't want to look at insured bonds anymore because of negative press," said James Iselin, a portfolio manager at Neuberger Berman. "It's more headline-associated risk than any kind of fundamental analysis of insurance."

Iselin said this discrepancy is "definitely a buying opportunity."

"Even if [insurance] has a minute amount of value, it still has some value," he said. "It shouldn't add additional yield."

No bond insurer carries a top-notch financial strength rating from all three ratings agencies. At the end of last year, seven did. The market is discriminating among the insurers, one trader said. Bonds insured by Financial Security Assurance and Assured Guaranty Corp., and to a lesser extent Berkshire Hathaway Assurance Corp., still trade as if the insurance adds some surety, the trader said.

Most of the others are subject to "large-scale discounting," he said.

WHEN IS A CORPORATE NOT ONE When it is a corporate-backed muni. Theoretically, it should make no difference. In today's market, "should" takes a backseat to liquidity.

In cases like industrial development bonds, pollution-control revenue bonds, or special-facility revenue bonds at airports, municipalities can sell tax-exempt bonds on behalf of corporations.

These bonds are backed by the corporations' credit, with municipalities serving as intermediaries to which investors rarely have any recourse.

These bonds have traditionally carried lower yields than the identical-credit-quality bonds of the corresponding corporations because of the tax exemption.

In a report earlier this month, Friedlander said some triple- and double-B rated corporate-backed munis are yielding dramatically more than their corresponding corporate bonds.

Some natural gas supply revenue bonds are yielding 150 basis points more than corporate debt backed by the same banks backing the gas revenue bonds, he said.

Friedlander expects this discrepancy to disappear "fairly quickly."

When markets face an imbalance of sellers and buyers, "pricing can get very irrational because there isn't anybody on the other side of the trade," Friedlander said.


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