Sell Side

An Uncertain Market

Projections for market metrics in the new year are far from unanimous, as uncertainties over interest rates, investor demand, and bond insurers have the municipal bond market on its toes.

While one expert projected a 15% to 20% decline in new-issue volume in 2008, others said they expect the flow of new bonds to hold steady at the 2007 level or even set a new record. The divergence started with differing views on whether we’re headed for an economic slowdown or even a recession.

“It depends a lot on interest rates,” said Tom Jacobs, managing director at the new broker-dealer Depfa First Albany Securities LLC. “The real question is what happens with the underlying economy.”

“If we have a soft landing, I think you could have interest rates very similar to where they are or maybe a little bit higher,” he said. “If we have a contraction, then they might get a little lower.”

Jacobs estimated that the municipal market would churn out $410 billion of bond sales during 2008. This would mean a 4% to 5% drop from the record-setting $429 billion sold last year, according to Thomson Financial.

Some muni bond strategists, such as Peter DeGroot of Lehman Brothers, called for a more sizeable year-over-year drop in issuance volume. DeGroot, who said he thinks about $350 billion of municipal bonds will be sold in 2008, said widening credit spreads, a drop in tax receipts, and a lack of market liquidity will curb refundings and leave new-money issuance “marginally lower” this year.

Analysts at Municipal Market Advisors, on the other hand, called for $440 billion of bonds in 2008.

“New-money volume follows persistent infrastructure needs, more difficult budgetary conditions that will precipitate deficit borrowings like [pension obligation bonds], and the execution of transactions postponed in 2007,” wrote MMA president Tom Doe in a research piece published last week.

By and large, sources echoed the view that an increase in capital-spending needs across the country will continue to drive up new-money borrowing. It’s the other side of the market that could change, they said.

“The biggest factor is going to be a decline in refunding volume,” said Michael Decker, senior managing director for research and public policy at the Securities Industry and Financial Markets Association. Decker’s team is in the middle of compiling data from a survey of sell-side muni-market participants in which the team asked what trends people expected to grip the market during 2008.

“A lot of deals that were potential candidates for refundings for this year were done during 2007,” Decker said, recounting the responses he’s gotten while conducting the survey.

But research analyst Ying Chen Li of JPMorgan said he thinks the lure for issuers to refund will not disappear with the widening of credit spreads, as others have suggested.

“Credit spreads are widening, but the level of widening is not enough to stop the refunding,” he said, adding that yields are still low by historical standards. Li has projected $430 billion of muni volume for 2008.

Sources agreed that they think municipal yield curves will steepen this year, though none said they thought the spread between yields on short and long maturities would approach the record levels reached in late July 2003, when the Federal Reserve Bank was holding its target rate at 1%.

The relationship between rates in the municipal market and those on Treasuries could also indirectly affect the way issuers approach the market this year. The divergence of these markets has made hedging difficult and brought pain to many of the hedge funds, broker-dealer proprietary desks, and other arbitrage investors in the municipal market in recent months.

“To the extent that [tender option bond] players continue to pull back from the market or at least don’t apply fresh capital to the market, that would put upward pressure on yields and spreads,” DeGroot said. That, in turn, could stunt issuance.

When muni levels approach taxable yields, however, more international players take notice, Li said. He said the solid credit profiles of muni bonds, along with their lack of correlation to other asset classes, makes them a good fit for most portfolios — even those not familiar with U.S. markets.

“If they don’t understand IBM or [General Electric Co.], they do understand California,” he said. “We think this theme is going to continue in 2008.”

California was by far the largest issuer of muni debt in 2007, and state officials have said they are looking to international investors as one source of new demand for the $61 billion of general obligation bonds the state has approved but not yet sold.

Questions over the value of bond insurance — now included on nearly half of the bonds outstanding — will also affect how borrowers sell their debt in 2008. As a result of recent reviews, the rating agencies put several of the bond insurers on negative watch, an opinion which typically implies the companies’ will be either downgraded or upheld within about 90 days.

Sources said during recent weeks that first the bonds backed by ACA Financial Guaranty Corp. and Radian Asset Assurance Inc. started trading based on the underlying rating of the bonds. More recently, those backed by even the triple-A insurers, such as MBIA Insurance Corp. have been valued based more heavily on the creditworthiness of the bonds themselves.

“I’ve been here for years, and its only in the last month that someone has said to me, ‘Can you check the underlying on these MBIA bonds?’ ” said Dick Larkin, municipal analyst at J.B. Hanauer & Co.

But even with a new round of opinions on the insurers’ credit ratings set to come out within the next few months, sources said they think doubts will remain.

“When will the end come in sight?” Larkin asked. “I don’t think anyone knows that — certainly not the rating agencies.”


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