Buy Side

Retail Investors Fighting for Scraps

Retail investors face a drought of new tax-free municipal bonds.

Federal legislation designed to broaden investor demand for state and local government debt has resonated.

Thanks to programs created or expanded under the federal stimulus, municipalities are floating fat batches of debt to banks and pension funds.

Retail investors are fighting for what is left over.

And with municipalities on pace to sell the lightest slate of bonds since 2004, the supply of tax-exempt paper in the primary market looks increasingly skimpy.

A municipal bond trader in New Jersey put it succinctly: “There’s no bonds out there.”

The shortage has helped fuel a mighty rally in short-term municipal debt.

It also poses a dilemma to municipal bond mutual fund managers, who are suddenly flush with cash precisely when short-term yields are historically low.

This phenomenon reflects pressures on both sides of the supply-demand equation.

Municipal bond sales are down 18% this year, according to Thomson Reuters. That is mainly fallout from the credit crisis.

The decimation of banks’ capital strength bumped many of them out of the market for selling letters of credit, which are a linchpin of variable-rate municipal debt.

Consequently, variable-rate debt issuance has tumbled 78% this year. Through July, variable-rate volume was off almost $65 billion, or $9.3 billion a month on ­average.

That alone is more than enough to explain the plunge in issuance so far this year, to $220.32 billion from $268.6 billion the first seven months of 2008.

For retail investors clamoring for ­­tax-exempt bonds, though, the story is more subtle than the overall decline in ­issuance.

Embedded in the American Recovery and Reinvesment Act, enacted in February, were two clauses currently siphoning supply from retail.

One is the biggest news in public finance this year: Build America Bonds.

This program enables municipalities to forgo the tax exemption on their debt and instead sell taxable bonds and opt to receive a federal subsidy equal to 35% of their interest costs.

The concept undergirding this clause was to allow municipal issuers to access a class of investors that does not pay taxes and therefore has no compulsion to bid on tax-exempt paper: pension funds, qualified accounts, foreign investors.

From April to July, state and local governments — including big, well-known names like California, the New Jersey Turnpike Authority, and the University of Virginia — sold $18.9 billion of BABs, or $4.7 billion a month.

Since the beginning of this decade, municipalities have sold an average of about $30 billion a month.

The BAB program has propelled taxable bonds as a share of the municipal market to the largest proportion since Thomson Reuters started keeping track in 1982.

More than 14% of municipal bonds sold in the last four months have been BABs.

“The BABs have stolen some of the tax-exempt supply,” said Matt Dalton, chief executive officer at Belle Haven Investments. “Supply’s going to be thin due to the alternative platform that these authorities can issue on.”

While it is not clear how many bonds sold as BABs would have been bound for the tax-exempt market if not for the program, tax-exempt supply is down more than $40 billion this year, or roughly $5.7 billion a month.

A second feature of the stimulus that is crowding out retail is the expansion of municipal bonds’ eligibility for tax-exempt holdings by banks.

Normally banks have to pay taxes on the interest collected on munis, even tax-exempt munis.

An exception is for debt issued by so-called bank-qualified governments, once defined as issuers that sell $10 million of bonds or less in a year.

The legislation passed in February temporarily redefined a bank-qualified issuer as one that sells $30 million or less in a year.

State and local governments have sold almost $19 billion in bank-qualified bonds this year, more than in all of 2008.

Less than six months after the stimulus passed, this is already the heaviest annual slate of bank-qualified bonds since 1998, and is comfortably on track to smash that year’s record of $23.8 billion.

Issuance of bank-qualified bonds — which retail investors are theoretically eligible to buy if they wish to bid against banks — is up more than $9 billion over last year.

A third factor not related to the stimulus is crimping issuance: a dearth of ­refinancing.

One reason for the slowdown in refinancing is a twist in the relationship between municpal market interest rates and Treasury market interest rates.

Say a municipality wants to borrow money to pay off existing debt that cannot be immediately repaid at the time the new debt is sold.

It typically sells long-term refunding bonds and uses the money to buy Treasuries that mature at the same time as the existing debt the municipality is paying off.  The municipality then keeps the Treasuries in escrow, and uses the interest and principal payments to pay off the bonds it is refinancing.

Here is the twist: if the Treasury yields less than the bonds being paid off, the refinancing becomes more expensive because the municipality has to come up with the difference.

That additional expense can inhibit refinancing.

According to the Municipal Market Data yield curve, the five-year Treasury yields 165 basis points less than a double-A rated 20-year muni.

That forms the basis for Bank of America Merrill Lynch muni strategist Phil Fischer’s negative arbitrage index, which, he pointed out in a report last month, “remains substantially negative.”

Sales of refunding bonds — the new bonds municipalities sell in a refinancing — are down 37.5% so far this year.

The decline is $28.8 billion, or $4.1 billion a month.

“The tax-exempt market is currently facing a significant shortage of new-issue product,” George Friedlander, muni strategist at Morgan Stanley Smith Barney, wrote in a report last week. “The volume of new munis is quite tight.”

Friedlander noted the $23.6 billion in munis issued in July was “far below historical trends.”

Municipalities sold an average of $31.3 billion in bonds in July the previous five years.

Volume in June was the lightest June since 2004 and volume in May was the lightest May since 2001. The shrinkage in supply coincides with a spike in demand.

A whirlwind of factors has herded buyers into municipals, especially intermediate- and short-term munis.

Investors and analysts cite a number of reasons, including an expectation that the top federal income tax rate will rise to 39.6% from 35%, and a preference for safer investments following a disastrous 2008 for stocks.

Much of the money flooding the muni market is coming from safe havens, which have recently borne yields that flirt with zero. Investors hoarded cash in Treasuries and money market funds in late 2008.

Now that conditions in financial markets have improved, investors appear willing to move money out of the most ironclad safe havens in search of better returns.

The tax-free money market fund industry has bled $81.49 billion since assets peaked one year ago, according to ­iMoneyNet.

That represents 15.4% of the industry’s assets under management at the time the outflows began. Meanwhile, a record-breaking sum of cash has poured into municipal bond mutual funds in 2009.

Muni funds have reported $41.8 billion in inflows so far this year, already demolishing the previous record for inflows over any 52-week period since AMG Data Services started tracking this data in the early 1990s.

The distension in the supply-demand balance has rendered short-term munis unprecedentedly expensive.

Some say the constant influx of cash forces buyers to continue buying, even if they do not really like the yields.

“Demand has far outstripped supply,” said a trader in New York. “There’s so much money, and they’ve got to buy something. Nobody really likes the rates. People are being forced to buy because they just have so much money.”

Belle Haven’s Dalton said he does not see this imbalance abating anytime soon.

“There’s just going to be too much money chasing too little bonds for some time,” he said.

Richard Ciccarone, head of research at McDonnell Investment Management, fears the narrowing of credit spreads in the past few months may not signal better credit quality. It may simply signal retail investors grappling with a shortage and settling for what is available.

Since the advent of BABs in April, the spread of the seven-year single-A over the seven-year triple-A has narrowed 40 basis points, according to the MMD scale.

Before credit analysts toss their calculators and head for the beach, Ciccarone said they should consider whether the spread-narrowing is a supply-demand dynamic.

“Those are bid up in price because that’s all that’s available for retail,” he said.


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