When institutional investors and price-evaluation services disagree, bet on the institutional investors.
That is the strategy Matt Fabian, managing director of Municipal Market Advisors, urges clients to take. Based on this advice, he said high-grade, five-year municipal bonds offer their best value all year.
The recommendation is predicated on an indicator Fabian claims has foreshadowed movements in the muni market reliably over the past two years. It pits investment firms against price evaluators, and assumes the investment firms have a better feel for where prices are heading.
Every day, MMA surveys about 50 firms, including dealers, mutual funds, hedge funds, and money managers. The mix of buy-side and sell-side firms is about half and half, Fabian said.
Participating firms include Oppenheimer & Co., Raymond James, Morgan Keegan & Co., and First Southwest Co.
The survey asks the firms what they think yields on munis all across the yield curve should be.
MMA seeks to construct a daily yield curve representing institutional investors’ consensus, based on the opinions of the surveyed firms.
MMA strips out quotes unusually deviant from the median and does some touching up to build the MMA consensus muni curve.
MMA then compares its municipal curve to the Barclays Capital municipal bond indexes, which measure pricing in the primary market and the pricing services’ evaluations in the secondary market.
“You’re going to get a picture of the market’s consensus of what the market should be worth, versus where the evaluators are pricing it,” Fabian said.
When the curves disagree, Fabian said index yields tend to revert to the MMA consensus yields.
When the MMA consensus yields are lower than the standard index yields, Fabian believes it means sellers are giving away too much.
In other words, investment firms think yields should be lower, and eventually the market will come around to their way of thinking.
“This has been pretty reliable through the last two years,” Fabian said. “Through the crisis, the market level has consistently reverted to the MMA consensus.”
This metric suggests sellers currently are conceding too much yield in high-grade five-year municipal bonds, Fabian said.
Investors looking for total returns over a quarter or so should buy munis in the five-year range, or funds or exchange-traded funds replicating their performance, he said.
“Those are showing the signs of seller concession,” he said. “There’s a bigger bias toward prices rising.”
One reason sellers are dumping bonds in this range is that nobody wants to be stuck with inventory, according to Fabian, who joined MMA in 2006.
Bonds in inventory are susceptible to the risk of interest rates rising. That would mean bond prices would come down before the inventory can be cleared.
This happened to several large firms at the end of last month, Fabian said.
Dealers used to be able to hedge muni inventory with Treasury futures, because muni yields and Treasury yields for years tracked each other with high correlation.
That enabled dealers to offset losses on munis in inventory with gains on Treasuries.
The credit crisis has obliterated that correlation, rendering hedging of muni inventory extremely difficult, Fabian said.
Rather than saddling themselves with bonds vulnerable to price declines, firms are accepting lower prices and selling them, he said.
Fabian, who was lead municipal research analyst for UBS AG before joining MMA, said this value does not extend out along the yield curve.
Value in the 10-year range is neutral based on the comparison of the MMA consensus and the indexes, while long-term bonds are too expensive, he said.
“There’s some yield-chasing” at the long end of the curve, Fabian said. “Buyers looking for yield have been willing to extend a bit.”
