WASHINGTON - Tax-exempt issuers will face a generally difficult and volatile economy in 2009, one that will challenge issuers as they try to sell debt during a recession expected to continue until at least the third quarter, economists and market participants said.
For the municipal market, there's hope in retail investors. Traders and analysts said long-term muni bonds are among the cheapest assets in the fixed-income sector. Alluring muni yields, coupled with federal economic recovery programs and low rates on Treasuries, will increase retail appetite for tax-exempt debt, sources said when asked about their outlook for the coming year.
Gross domestic product will contract by 2.2% in the first quarter of 2009 and by 0.1% in the second quarter, according to the median estimate of 22 economists surveyed by the Securities Industry and Financial Markets Association between Nov. 24 and Dec. 5. The economists expect fourth-quarter GDP in 2008 to shrink by 4.2%, the largest contraction since the first quarter of 1982. They also forecast that employers will shed 1.5 million jobs in 2009 and that consumer spending, which accounted for 70.5% of GDP in the third quarter, will drop by 1.0% for the year.
If economists are correct and the current recession continues for another six months, then it will be the longest period of economic weakness since the Great Depression. The previous two recessions in 2001 and 1990-91 both lasted eight months from peak to trough, according to the National Bureau of Economic Research. The current recession, now in its 12th month, is the longest since the 1981-82 recession, which lasted 16 months.
The forces dragging down the economy in the second half of 2008 have created "a bubble in fear" among investors, said Robert DiClemente, chief economist at Citigroup Global Markets Inc. The "euphoria-driven extremes" seen in the dot-com and housing sectors have reversed and fear in the marketplace is accelerating a downward spiral, he said.
The bubble is "now mutually reinforcing: the financial system has taken the economy down [and] the weakness in employment is imposing greater losses on financial firms," DiClemente added.
"The economy is in a tailspin. We're in a severe recession," said Laksham Achuthan, managing director at the Economic Cycle Research Institute, which calculates indexes of leading indicators used to predict the business cycle. Those indicators point toward more bad news ahead.
"We don't see an upturn yet. It's going to get worse in the months ahead," he said.
Meantime, the municipal market has suffered from investors' fears and the ongoing recession.
This year "was a credit crisis year," said Dominick Mondi, senior managing director of municipal trading at Mesirow Financial in Chicago. "It came at you in every way possible and it didn't stop."
| Michael Decker |
Many traditional muni buyers turned into net sellers and added supply to the market such as property and casualty insurers, most notably American International Group Inc. Hedge funds also sold munis to raise cash and mutual funds unwound their tender-option bond programs, said Michael Decker, co-chief executive officer of the Regional Bond Dealers Association.TOB programs were "the predominant force" in the muni market for the last six years, accounting for 55% to 60% of new issue sales, according to Peter Delahunt, national sales manager at Raymond James & Associates in New York.
Muni mutual funds bought long-term muni bonds and used them as collateral to issue short-term debt. The funds profited from the difference in interest rates. Investors were willing to buy the TOBs at lower interestrates because the tender option allowed them to sell the bonds back to the issuer at designated intervals.
But "most of the TOB game is over," Delahunt said.Vestiges of TOB programs will remain, but leveraged at two times, rather than 20 times, the value of the collateral, he said, adding: "You can see that takes a huge component out of our demand universe."
Mutual funds also became net sellers in the last weeks of December. Municipal mutual funds had a net outflow of $993 million for the week ending Dec. 13, according to AMG Data Services. Mondi said that investors would rather sell their muni fund assets than take more significant loses by selling from an equity portfolio.
The traditional investors "are not likely to come back in the near term," Decker said. "Who, if anyone, will come back as the marginal buyer of municipals?"
Selling pressures have left the muni market "thin and erratic," George Friedlander, managing director and fix-income strategist at Citi, said in a Dec. 12 research release.
| Peter Delahunt |
The sell-offs by property and casualty insurers, hedge funds, and mutual funds have also created an enticing buying environment, according to Friedlander and others. Yields on some higher-rated paper, such as double-A hospitals and state housing agencies, have been pushed to "extremely distended levels," widening yield spreads. These conditions have created an "accordion effect" in the muni market, Friedlander said."As yields on weaker or higher-yielding sectors are pushed sharply wider, it puts pressure on the next-highest yielding paper, and the paper next to that, and so on." Friedlander said. "As a consequence, yield spreads in all sectors are pushed wider in comparison with the triple-A yield curve."
The institutional exodus has left depressed prices but attractive yields in its wake. Market participants said they see retail buyers as the main source of demand or going into next year.
"There's only one taxpayer left out there, and that's retail," Delahuntsaid, adding that this year, "retail has been the strongest component of the demand universe."
In the coming year, the market can expect crossover buyers from taxable corporate bonds, sources said. Muni credit concerns are minimal compared with the corporate sector and those investors will seek safe yields while soaking up some municipal supply.
"You've got to the point where muni bonds are cheaper than any of their comparable counterparts in the fixed-income universe" even on a pre-tax basis, Delahunt said.
A buying spree is expected to extend along the yield curve as investors' appetite for risk grows and they seek higher returns.
With yields in the muni market "so enticing, we expect more cash to be moved out along the yield curve," Friedlander said.
The simple demographics in the U.S. mean more investors will take advantage of the attractive yields now, Mondi said. As the population ages, investors tend to distribute more of their portfolios toward fixed-income assets.
"There's just incredible value in munis," said Robert MacIntosh, chief economist at Eaton Vance Corp. "People are still going to pay taxes, and eventually probably pay more," he said, referring to tax increases for high-income Americans President-elect Barack Obama called for during the election campaign. However, none of the sources expect Obama's tax hikes to come next year amid the continuing recession.
Some sources said, however, that the nature of retail buyers will not make up for the institutional absence. Retail investors are not as aggressive as institutional buyers in the muni market and do not trade in such quantities, Decker said.
To promote a new institutional buyer, the RBDA will lobby Congress next year to amend the bank deductibility limit. Currently, commercial banks are allowed to deduct 80% of the costs of purchasing and carrying tax-exempt bonds issued by municipalities whose annual bond issuance does not exceed $10 million. The RBDA wants Congress to expand that annual limit to $30 million to entice banks to buy more municipal debt.
| George Friedlander |
As rising yields for more highly rated paper have provided the carrot for retail demand, the Federal Reserve might be the big stick prodding it in 2009, sources agreed.The Fed has made a series of interest cuts that have pushed the yields of Treasuries to historic lows. The latest Fed action came on Dec. 16 when it lowered the fed funds rate to a range between zero and 0.25%, a 400 basis point drop from January when the rate was 4.25%.
The target rate is the rate at which banks lend balances at the Fed to other banks overnight. Low yields in Treasury securities, as well as certificates of deposits, have pushed investors who cloistered their cash in the safest assets toward higher-yielding municipals, sources said.
"We should not underestimate the potential benefits of the Fed's extraordinary actions of Dec. 16," said John Lonski, chief economist at Moody's Investors Service. "Those actions are intended to induce investors to assume more risk [and to] increase their exposure to state and local bonds."
Many state and local advocacy groups have been disappointed by the Fed's unwillingness to help issuers during the credit crisis. For example, the central bank has not opened its commercial paper funding facility for tax-exempt issuers. The Fed told lawmakers that Section 13-3 of the Federal Reserve Act, which it has relied on to lend to corporations, explicitly excludes state and local governments.
But from a monetary standpoint, "the Fed has done everything correctly" by providing liquidity and cutting interest rates, Mondi said, adding: "The spread differentials between governments and municipals now has made municipals a very, very attractive product."
If market participants are correct and demand accelerates next year, then issuers will have greater ability to sell debt. New issuance is expected to be $390 billion in 2009 - on par with this year, according to an estimate by Loop Capital Markets LLC in Chicago.
"The second half will be heavier volume than the first half because liquidity conditions will improve," said Chris Mier, managing director at Loop Capital. He said he expects issuance to accelerate with pent-up buy-side demand in the second half of 2009.
Given what municipals have endured in 2008 - monoline insurers downgraded, the collapse of the auction-rate securities market, and a liquidity and deleveraging crisis - the market has shown resilience, according to Mondi said. And he sees great potential in the New Year.
"What's going to happen in 2009, that credit appetite is going to increase," Mondi said. "When credit appetite starts to increase, you have a much more liquid and viable market place."
