Buy Side

Muni Relatively Cheap, But Absolutely Expensive

Municipal bonds are a relatively inexpensive buy when compared to other taxable bonds, but absolute yield levels are quite low by historic standards.

This poses a quandary for investors looking to put money to work. Muni yield levels are lower than investors want, but cheap when compared to other markets. The current market conditions exist because a series of different events that occurred in the fourth quarter last year. With the holiday season done and the market beginning to speed up, participants disagree on whether the relative cheapness of munis, compared with other fixed-income asset classes, is drawing buyers back into investing.

The 10-year yield according to Municipal Market Data’s for triple-A general obligation bonds was 3.43% Wednesday. A rule of thumb is that retail investors will enter the muni market when a 10-year, 5% coupon can give them a 4.0% yield. That is 57 basis points from where the market was on Wednesday. On Jan. 12, 2006, the MMD’s 10-year yield read 3.75%. On Jan. 12, 2001, the same scale yielded 4.23%.

“Overall yield levels are challenging,” said Richard Taormina, a portfolio manager for JPMorgan Asset Management’s Tax Aware Real Return Fund. “Although it is not as easy as it was, we are finding some cross-over buyers that we think for capital needs are exiting the market and that has provided some opportunities to buy some paper, but you have to be ready because the bonds trade quickly. People are looking around right now and finding everything pretty expensive across the securities spectrum, so its tough for a lot of us.”

In the past few weeks, the Treasury market has firmed significantly, and while munis have followed, they have greatly under performed. This principally has been a flight to quality rally for Treasuries as other securities markets continue to be plagued by the subprime default crisis. Munis were not spared.

“The difficulties in the subprime market have had a general effect on anything that was different from Treasuries and it was exacerbated by the fact that people who were having liquidity issues sold into the municipal market because they could actually get a bid there,” said Cathryn Steeves, vice president and portfolio manager at Nuveen Investments, who manages $8.4 billion in several state-specific funds. “So the Treasury market ran as a result of all these problems, and the municipal market just couldn’t keep up because it do was coping with the subprime impacts on the insurance industry and on the broker-dealers.”

From Dec. 14 through Jan. 9, the MMD triple-A yield scale for 10-year bonds declined 24 basis points to 3.43% from 3.67%. Treasury bonds maturing in 10 years fell 43 basis points during that same time period to 3.80% on Jan. 9 from 4.23%, or almost twice as far as tax-exempts.

As munis have underperformed Treasuries, they have become relatively cheap, reaching relative levels that in the past have triggered retail-led rallies.

“Munis should be characterized as cheap right now,” said Phil Condon, head of municipal bond portfolio management at DWS Scudder. “We are seeing a relative value right now that screams ‘buy.’ But that isn’t happening just yet and the reason is because the real story is not that munis are cheap, but that Treasuries are rich. They are rich to every asset class right now.”

Based on the MMD yield curve, as a percentage of a Treasury yield for Wednesday’s end-of-day yields, municipal bonds were offering investors 90.3% of Treasury levels. The one-year average for this relationship is 83.3%. The higher the percentage, the cheaper munis are, and this information does not take into account the after-tax yield, which would drive this percentage higher. The same comparison for 30-year bonds was 95.8% Wednesday and the one-year average is 89.3%.

Looking purely at these percentages, Dan Genter of RNC Genter Capital Management, said he thinks that munis are an investment that cannot be overlooked.

“You won’t find too many things in the investment industry that are just absolute lay-ups,” Genter said. “To be able to buy bonds at these levels is amazing, and anyone who doesn’t take advantage of it is going to look back at this time down the road and realize how obvious this investment was.”

While Genter thinks munis are the way to invest right now, Condon is somewhat more cautious. Condon pointed to the London Interbank Offered Rate as evidence. The Libor swap curve is a better representation of the taxable bond market as a whole, he said, and looking at the municipal bond market’s relationship to it, shows that munis are not the only relative cheap asset class right now, he said.

“When you compare the muni market to Libor it is a different story,” Condon said. “We are not as cheap to Libor as we are to Treasuries and it just gets to my point that Treasuries are truly rich, but when you turn to the broader taxable market, there are many corporate bonds that are also a good buy. Some of our taxable bond funds that can cross over into munis really haven’t because taxables are also cheap.”

This could have also tempered demand for munis by cross over buyers.

Comparing MMD to Libor proves Condon’s point. Using Wednesday’s closing levels, 10-year munis were 78.1% of Libor and 30-year munis were 86.1%. As these ratios are lower than the muni-Treasury ratios, showing that munis are less cheap to the broader taxable market.

Given these conditions, portfolio managers question whether investors are coming back to munis with vigor.

Steeves believes it is too soon to tell whether retail investors are getting back into the market. She believes that they won’t be very active until the absolute levels rise considerably. She also said retail investors’ discomfort with the credit health of the monoline bond insurers may result in a prolonged delay before they want to buy munis again.

Where Steeves was somewhat hesitant, both Condon and Taormina said they are beginning to see some interest. Both fund managers said the large wire houses are beginning to see some demand from retail buyers and their own fund flows are beginning to grow.

“We are seeing some more interest from retail right now, but until the insurance situation is resolved I don’t believe we are going to see a huge increase,” Condon said. “Investors need to reevaluate what they want out of muni bond fund, as we have had this aggressive high-yield run over the past few years, and somewhere the message was lost [of] what it really means to invest in a bond fund. Munis are a safe asset class, and if invested wisely, they are a smart buy even during these volatile times for fixed income.”

One thing that most market participants can agree on is that the hedge funds and arbitrage accounts, while getting back into the market right now, are doing so at a slow pace. While they are not large holders of municipal debt, these participants are very active in the secondary market, and in many cases drive overall market prices as a result. Their lack of involvement at this point makes for an illiquid secondary and makes price discovery difficult, Condon said. Coupled with the problems concerning subprime, the market is difficult to navigate.

“The hedge funds and arbs have watched munis behave differently from what they have normally experienced, so they are a bit more concerned,” Steeves said. “We hear they are back in the market but they have to be much more vigilant of the credit quality, and all in all it has reduced their participation and also helped drive values wider.”

Condon also pointed to the Libor curve as a reason for their reduced involvement, as many of these funds hedge their investments based on this swap curve. The cheaper munis are to Libor, the better the hedge pays, so it isn’t very attractive right now.

Overall, most participants said the real test will be when the primary market kicks into full gear. With The Bond Buyer’s 30-day visible supply at $10.672 billion, the market will find out soon.

“If you look at the long-term fundamentals of municipal bonds, on a relative basis at the very least, they look like a good buy,” said Joseph Baxter, senior portfolio manager at Delaware Investments. “You look at the fact that on a relative basis, they are cheap; you look at the fact that default ratios remain very low compared to other asset classes; and lastly you look at taxes and they are not going down.”


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