Buy Side

Retail Embarks on a Search for Supply

With municipal volume down nearly $50 billion so far this year, retail investors are having to look outside their comfort zones to add value to their portfolios, municipal analysts, trading, sales, and underwriting sources said.

Finding bonds when they are scarce means looking longer and farther afield geographically and on the credit scale.

Retail investors are reaping rewards by buying bonds with longer maturities and on a much smaller scale, buying out-of-state paper. Some are forgoing general obligation bonds - perceived as more vulnerable to state budgetary shortfalls - and turning to revenue debt. Others still are venturing into lower-quality bonds or buying taxable Build America Bonds in the secondary market, sources said.

Individuals are using these strategies to overcome the 18% drop in new issuance in 2009 to $220.32 billion as of July 31, compared with $268.6 billion over the same period in 2008, according to Thomson Reuters. In addition, refunding volume fell by 37.5% as a result of the abnormal yield relationship between municipals and Treasuries that continues to make it less cost effective for issuers to refinance.

Analysts say retail is making the best of a bad supply situation at a time when a fickle stock market and the threat of higher taxes is intensifying interest in tax-free investments, thereby further straining the imbalance of supply and demand.

"There's not as much paper in the market and there is less tax-exempt issuance with the creation of BABs, but there are still bonds available for retail," said a managing director of underwriting at a large New York firm. "Mom-and-pop investors are gravitating toward whatever is available in the market."

For instance, to avoid paltry yields on the short end of the curve, many investors are "expanding their vision" in order to take advantage of attractive yields on the long end of the municipal market, according to Chris Mier, municipal strategist at Loop Capital Markets LLC in Chicago.

"Retail has a strong aversion to 30-year bonds, but if retail investors confine themselves to the short part of the curve, they will never experience the beauty of getting paid significantly for maturity extension," he said.

On Tuesday, for example, generic triple-A GO bonds due in one year were yielding 0.40%, while those due in five years were yielding 1.73% and the 10-year bond was yielding a 2.96%, according to the scale published by Municipal Market Data.

Mier said Loop has been "hawking the 'sell 20-year, buy 30-year' trade" to retail investors because of the opportunity to add value by extending. Also on Tuesday, the 20-year generic, triple-A GO bond due in 2029 was yielding 4.07%, according to the MMD scale, but investors who extended to 30 years earned a 4.56% yield in 2039 - more than 100% of the yield of the 30-year Treasury bond, which on Tuesday yielded a 4.35%.

"The odds that a 30-year bond will get advance refunded, or current refunded, at some point during the anticipated 30-year holding period is pretty good," Mier said. "This would improve the quality of their bond, while significantly shortening their maturity.

George Friedlander, managing director and municipal bond strategist at Morgan Stanley Smith Barney, said while retail remains resistant to the long end, they are agreeing to extend nonetheless to escape the meager yields hovering between 0.40% and 1.02% in one and three years, and sub-2% in five years.

"We are seeing more people leaving some money in cash and going beyond five and seven years to find yield, creating more a barbell structure that ever before," he said. "The flows into the limited-term mutual funds have been massive and that is keeping the supply on the short-end tight and [prices] rich."

Meanwhile, two other ways retail investors working with his firm are finding relief from the market's scarcity is buying out-of-state bonds and buying revenue bonds instead of GOs, Friedlander said.

"While GOs may be theoretically stronger, a good-quality revenue bond is more resistant to budget crises," he said. "We have been encouraging the use of decent-quality revenue bonds versus GOs to a significant degree."

In addition, going out of state increases investors' options and the supply they have to choose from while also giving them geographical diversification of credit risk, while still providing enough yield - even after being subject to in-state taxes, he said. "With the yield curve sloped so steep, if you go out a little more in maturity you make that up," he added.

Others agree that their clients are benefiting from extending their maturities and investing outside of their typical investing patterns, among other strategies.

"With money market rates next to zero, retail investors are being forced out on the long end of the curve in their pursuit of value," said Rick Calhoun, first vice president of retail sales and trading at Crews & Associates Inc. in Little Rock.

"The thin supply combined with other market forces has pushed rates to historical lows in retail territory so investors are exploring alternatives to school bonds and local GOs," he added.

Calhoun said that was the case when $98.3 million of thermal electric revenue bonds from the Harris County, Tex., Cultural Education Facilities Finance Corp. met with strong retail demand.

The attractively priced issue enticed retail investors to the 2021 maturity, which was priced with a 4.52% yield and rated Aa3 by Moody's Investors Service and AA by Standard & Poor's.

At the time the deal was priced on Aug. 4, the generic, triple-A GO scale in 2021 was yielding 3.33% and the double-A GO scale was yielding 3.53%, according to MMD.

The yield differential was enough to entice investors to opt for the utility bonds instead of traditionally retail-friendly, plain-vanilla GOs, Calhoun said.

Indeed, individuals' quest for bonds can prove challenging given that municipalities are poised to sell the lightest slate of new bonds since 2004 and investors are not seeing the extremely robust supply of just two years ago. Municipal issuance hit a record $427.6 billion in 2007, rising 10% from $383 billion in 2006 and soaring past the $406 billion record set back in 2005, according to Thomson.

For many retail investors, uncovering value has meant adapting to the drastic changes that have transformed the credit landscape, price, and spreads in the market in the last 12 to 24 months, sources said. The drop in issuance as a result of the fallout from the credit crisis, in addition to the 60% drop in bond insurance market so far this year, are major changes to which retail is still adjusting, analysts said.

"Such market conditions are forcing retail investors to reevaluate their traditional parameters of rating, price, and maturity," Calhoun said.

"With record-setting lows in the stock market, many investors are still finding that municipal bonds offer a safe haven for those looking for preservation of capital," he added.

Despite the supply drought, low absolute rates, and some fear of inflation, the safety and taxable-equivalent yields offered by municipals are sustaining demand among high-net-worth retail investors and convincing them to extend on the curve, added Richard Ciccarone, managing director and chief research officer of McDonnell Investment Management LLC in Oak Brook, Ill.

Meanwhile, the deterioration of bond insurance is causing some retail investors to dip slightly in credit quality to boost their yields.

Calhoun said investors that want to keep their laddered portfolios evenly distributed out to 10 or 15 years are moving to lower credit quality to enhance return - instead of extending their ladders.

"Retail investors have shifted away from insured bonds and the entire industry has returned to looking at the issuer's fundamentals," he said. "There are insured bonds with good fundamentals that are trading at attractive levels because of withdrawn ratings."

Andrea Hosbein of Cypress Capital Partners LLC in Chicago said insurance has become irrelevant for retail investors looking for the best bang for their buck, and has increased the demand for professional money managers among individuals more than ever before.

"A money manager who possesses strong credit analysis gives those investors the ability to confidently buy slightly lower-rated bonds - which are currently trading at historically wide spreads - and pick up significant yield and return in the future," she added.

On their quest for yield, some retail investors are also dabbling in the taxable municipal market thanks to the explosion of BAB issuance this year, according to Bill Mason, senior vice president of municipal trading and underwriting at David Lerner & Associates Inc. in Syosset, N.Y.

The creation of the BAB program as a result of February's American Recovery and Reinvestment Act has pumped more than $20 billion of new taxable municipal debt to market to date at a time when retail investors faced with low tax-exempt supply continue to clamor for new paper.

While they are largely an institutional product, BABs are being purchased by some retail investors in the secondary market for their comparable - or higher - yields versus similarly rated taxable instruments, sources said.

Mason said 25% of his firm's business has been focused on taxable municipals in the last few months, thanks to the swell of BAB issuance. "Life has been brought to a stagnant market," Mason said of the taxable municipal arena.

"That market was crawling along with very few participants, and now with more issues coming to market, it is like a breath of fresh air," he said. "With the previously limited supply of taxable municipal bonds, combined with tight spreads relative to the Treasury market, there was very little interest in taxable municipals for the retail investor."


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