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Demand for Some Bonds Falls Off; Diversity Becomes an Issue

The composition of municipal bonds coming to market is making it harder for some investors to diversify their portfolios.

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Muni issuance is off only 1.9% for the first three months of the year compared with the first three months of 2008, according to Thomson Reuters.

This obscures an important shift in the municipal landscape: demand is strong for high-quality general obligation state and local government debt. Not so for many other types of munis.

So while the $83.81 billion of issuance so far in 2009 is not down much from the $85.4 billion in the same period last year, that volume comes from just 2,249 issues. Volume has only declined 1.9%; issues have declined 9.5%.

That means the average bond sale is bigger - $37.3 million through March 2009, compared with $34.4 million last year.

It also means selection is not as diverse.

California added $6.54 billion of its debt to the market in the third-biggest tax-exempt sale in history last month. Wisconsin pulled off a $1.53 billion sale in March and New York's Empire State Development Corp. closed a $1.08 billion deal in January.

For portfolios thirsting for smaller issuers, though, the pickings are decidedly slimmer.

Offerings from Louisiana, Nevada, and especially Puerto Rico are down sharply this year.

Issuance has also shriveled within certain sectors. Development bond issuance is down 93.8% so far this year. Environmental facilities bonds are down 84.2%. Electric power bonds are down 73.3%.

The result of the market's preference for bigger, higher-quality deals is less choice for investors. And less choice makes it more difficult for investors to balance the bonds in their portfolios.

"The first rule of portfolio creation is not to put all your eggs in one basket," said Philip Fischer, municipal strategist at Bank of America-Merrill Lynch. "The concentrations by type and by region simply make it more difficult. .... The risk comes in the event that you have too much exposure to a particular sector or a particular state or region."

He pointed out the six biggest states account for almost half the new-issue market so far in 2009.

Issuance by the five biggest issuing states is down 11.4% so far this year. Issuance by the five smallest issuing states is down 28.2%.

Issuance of GO bonds is up 13.6% this year. Issuance of revenue bonds is down 11.2%.

Even among insured bonds, which now represent just 12.9% of new issuance, choices are limited. For 2008, more than 90% of credit-enhanced bonds were insured by either Financial Security Assurance Inc. or Assured Guaranty Corp.

Buck Stevenson, a high-yield muni portfolio manager at Silvercrest Asset Management, said selection is particularly problematic for high-yield investors.

Stevenson likes to make sure he never has more than 3% of his portfolio in a single issuer.

Achieving that dispersion is becoming tougher, he said, because the spike in rates for issuers with ratings lower than single-A has forced many of them out of the market.

Many projects are not justifiable at the rates investors are demanding on high-yield bonds, Stevenson said. That squeeze on supply has crimped his options.

He now has to rely mainly on the secondary market to find certain high-yield bonds.

"You are starting to see it becoming more difficult to diversify," Stevenson said. "There is a lot less [high-yield] supply coming to market."

More than a third of the bonds issued this year have been classified as general purpose, according to Thomson. Last year at this time, general purpose bonds were barely more than a fifth of the new-issue market.

The appetite for general purpose bonds comes at the expense of certain neglected sectors. Issuance of development bonds has tumbled to $387.1 million in the first three months of the year from $5 billion through March of last year. New supply of environmental facilities bonds has plunged to $334.2 million from $1.95 billion.

The two biggest sectors of the municipal market - general purpose and education - constitute 62% of new issues so far this year. For the first three months of 2008, general purpose and education constituted 43% of new supply.

John Mousseau, portfolio manager at Cumberland Advisors, disagreed that diversity has become much of a challenge.

New supply features a pretty good mix of names, he said.

"I haven't had a real problem in terms of finding paper," Mousseau said. "There's plenty of smaller deals. ... If you're willing to be patient there's been a pretty good diversified amount of bonds to be able to pick and choose from."

Indeed, while 49% of new supply comes from the biggest six issuing states, last year at this time the six biggest states had contributed 54% of new issues.

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