The technicals and the fundamentals are at war.
In a conference call outlining their outlook for 2010, muni strategists at JPMorgan argued horrific fundamental headwinds will engage in a “tug-of-war” with strong technical support to determine the municipal market’s fate.
Overall, they expect municipal bond prices to drag but yields to remain historically low relative to Treasury bonds.
They expect around $415 billion in new issuance — likely a bit more than this year’s volume — and a flatter yield curve as the Federal Reserve begins slowing its expansion of the money supply.
On the fundamental side, things have rarely been worse for state and local governments.
The economy has shrunk 2.5% in the past year, according to the Department of Commerce, and the unemployment rate hovers at 10.2%.
The decline in output and employment has visited havoc upon state and local budgets.
State and local government tax receipts tumbled 6.6% in the third quarter versus the third quarter of 2008, Commerce says. Income taxes plunged 18% and sales taxes shriveled 5.7% in the same period.
Meanwhile, municipalities could not offset shrinking receipts with spending cuts because demand for government services spikes during a recession.
“The unemployed turn to the government for assistance at the precise time the government cannot afford it,” said Chris Holmes, muni strategist at JPMorgan.
States face a total combined budget gap of $350 billion for next year and 2011, based on an estimate by the Center on Budget and Policy Priorities.
Localities normally depend on higher levels of government for as much as a quarter of their revenue, according to JPMorgan. That source of money is also likely to shrink, the strategists said.
“To help balance their budgets, states often slash transfers to municipalities and school districts,” Holmes and his colleague Alex Roever wrote in a report earlier this week. “Given the trajectory of state budget gaps and the unemployment rate, these cuts will likely continue in 2010, putting additional fiscal strain on local governments.”
It gets worse. One shoe is yet to drop, the strategists said.
Property tax receipts, the primary source of revenue for local governments, actually increased 2.7% in the third quarter. How this happened several years into a historic collapse in housing prices is a structural quirk in public finance that is likely to clobber municipalities next year, the strategists said.
Property taxes are typically assessed on the most recently valued price of a home. Even though prices have been falling steadily, governments’ revaluations of the properties have not yet caught up.
“While the recession has already begun to ravage state balance sheets, local municipalities have yet to feel its full brunt,” the strategists wrote. “Property value assessments tend to be infrequent and lag changes in house market values. ... We expect pressure on revenues to mount in coming quarters as assessments start to catch up.”
While the strategists at JPMorgan expect defaults to be concentrated among low-rated issuers in the hospital and housing sectors, these budget strains pose real threats to the municipal bond market.
Big state and local government budget deficits traditionally pull down municipal bond values, the strategists said.
Pushing up against these fundamental factors is a technical dynamic that bodes well for municipals.
The Build America Bond program reshaped the market in 2009, enabling municipalities to float more debt in the taxable market. Pushing issuance into a different market squeezes supply in the tax-exempt market.
JPMorgan expects $110 billion in BAB issuance next year on top of $57.51 billion in issuance this year plus whatever issuers sell for the rest of 2009.
All that taxable supply is making tax-exempt paper more scarce and supporting prices, they said.
Further, the Fed’s commitment to keeping interest rates at zero poses a conundrum to investors. The yield on tax-free money market funds is just 0.04%, according to iMoneyNet — the lowest ever.
Investors, who have more than $400 billion stowed in tax-free money market funds, are thus forced to choose between earning essentially nothing on their money or stomaching more risk.
This year, they chose to take more risk. Investors spirited $82 billion out of money market funds this year, according to the Investment Company Institute, and entrusted $73.59 billion to municipal bond mutual funds, according to Lipper FMI.
Mutual funds armed with all that cash were forced to buy tax-exempt paper and provided a pillar of support for the market.
The strategists at JPMorgan expect that trend to continue, albeit at a slower pace.
Fund flows have slowed down a bit lately, tapering to a pace of about $1 billion a week over the past four weeks, compared with a four-week average of $2.9 billion in early October.
Still, many investors cannot tolerate zero returns and will continue to shuttle their cash out of money market funds and into the tax-exempt bond market, the strategists said.
Holmes said he expects investors to pour an average of perhaps $700 million a week into muni bond mutual funds, which is still historically high.
All this adds up to an “interesting year,” they said.
The strategists believe muni yields are “susceptible to upward pressure.” They look for yields generally to trend higher.
JPMorgan does not expect the Fed to raise its target for short-term interest rates until 2011, but the unwinding of the central bank’s liquidity programs as well as the market’s expectation for a higher federal funds target rate will push rates higher next year, they said.
Intermediate investors should stay at the 10-year maturity range, they said, while long-term investors should favor 30-year munis over those in the 20-year range.
They expect the ratio of 10-year triple-A municipal yields based on the Municipal Market Data scale to 10-year Treasury bonds to range between 78% and 85%, much lower than the ratio the first half of this year. It is currently at 80%.
A lower ratio indicates a stronger valuation of municipals relative to Treasuries.
Although economists at JPMorgan expect the economy to grow 3.3% in 2010, Holmes and Roever said municipalities still face the risk of downgrades by the rating agencies and other headline risks.
