Buy Side

Long-Term Munis Hang In

JAN 11, 2010 7:37pm ET
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Long-term municipal bonds have demonstrated unusual resilience against the market’s walloping of Treasury bonds in the last six weeks.

Normally, one would expect a spike in Treasury rates to force some investors out of the municipal bond market. If for no other reason, municipals lose luster if risk-free federal government debt yields much more by comparison.

Some analysts and strategists, though, say the same imbalances that helped drive the rally in municipals last year are helping shelter the industry from a tough stretch for Treasuries this year.

Since the beginning of last month, the bond market has pummeled Treasuries. The yield on the 30-year Treasury has lofted from 4.21% at the end of November to 4.68% at the end of last week.

Long-term munis have not only endured this selling — they have rallied.

According to the Municipal Market Data scale, the 30-year triple-A muni yield has shed 15 basis points in that time period.

The 30-year muni-Treasury ratio — which describes the 30-year triple-A muni yield as a percentage of the 30-year ­Treasury yield — has contracted to 88% from more than 100% at the end of ­November.

Matt Fabian, managing director of Municipal Market Advisors, wrote in a report this week that municipal yields may set new all-time lows versus Treasuries this year as the “dearth of high-grade supply” meets “excessive demand.”

The decoupling of Treasuries and municipals is old news.

It used to be that Treasury rates and municipal rates moved in the same direction by similar magnitudes most of the time.

The correlation between the two yields was so dependable that for years the muni-Treasury ratio was a standard benchmark in municipal valuation.

Many traders and dealers used Treasury derivatives to hedge unsold municipal inventory, because they believed any change in the municipal rate would be accompanied by a similar change in the Treasury rate.

A consistent muni-Treasury ratio expressed the idea that, with a few exceptions, municipals and Treasuries responded to the same factors: interest rates, inflation, and economic growth.

The credit crisis changed that.

When panic gripped the markets, investors had no tolerance for the illiquidity and credit risk that afflict municipals. The whole world bought Treasuries and sold municipals, and the 30-year muni-Treasury ratio skyrocketed to a once-unfathomable 208.2%.

With markets settled down, municipals and Treasuries remain decoupled.

Treasuries have been battered lately as the predominant theme in the market shifts, Janney Montgomery Scott head of fixed income Guy LeBas wrote in a report this month.

For much of last year, investors were primarily concerned with cocooning their money and were not so attentive to yields, he said. Investors bought risk-free Treasuries at historically low yields just because they were risk-free. In December 2008, a three-month Treasury bill even traded at a negative yield.

As the year wore on and the economic outlook improved, LeBas said, the focus began shifting to achieving better returns on investments.

With investors starting to feel out when the Federal Reserve plans to increase its target for interest rates, he said the market for Treasuries has become much more challenged. The sale last year of $1.5 trillion in new federal debt does not help either, according to LeBas.

Meanwhile, municipals tell a different story. The market is characterized by rampant demand and too little supply to sate it, some strategists say. That is buoying municipals even as Treasury yields spiral higher.

“The long-term muni market has resisted the updraft in yields on Treasuries,” George Friedlander, municipal strategist at Morgan Stanley Smith Barney, wrote in a report last week. “It reflects a key reality in the muni market: demand has dominated supply for the past year, and we see no reasons for that pattern to reverse any time soon.”

In his “Municipally Speaking” column, Thomson Reuters analyst Michael Bouscaren said many investors are ignoring the selling pressure in the Treasury market and “looking more deeply into the technicals” in municipals.

Technical factors have continued funneling cash into the municipal market regardless of the fundamentals.

One of the primary technical factors is the siphoning of supply from the tax-exempt market by the Build America Bonds program. Enacted through the American Recovery and Reinvestment Act in February, the BAB program created a taxable form of municipal debt.

The program has been a smash. Municipalities issued more than $84.4 billion in taxable debt in 2009, including $64.121 billion of BABs, easily a record. For all the talk of the second-heaviest municipal supply in history last year, sales of tax-exempt paper actually decreased 5.8%.

For the traditional tax-paying buyer of municipal bonds who is seeking a tax-exempt investment, the market is suffering from a shortage.

As long as the BAB program, with its 35% federal interest cost subsidy, remains available state and local governments’ preference for floating debt in that market is likely to continue pulling supply away from the tax-exempt market. The BAB program is scheduled to sunset Dec. 31, 2010. The strategists at Loop Capital Markets have predicted BABs issuance this year could reach $130 billion.

Considering most BABs come to market with maturities of 12 years or longer, Friedlander said the program has blown a “hole” into long-term municipal supply.

“Long-term new issuance has virtually disappeared from the tax-exempt sector,” he said, referring to general-purpose government credit.

This scarcity has been met with overwhelming demand, which Friedlander mainly attributed to paltry returns on short-term safe havens.

At the end of the third quarter, households held $7.74 trillion in safe havens such as bank deposits and money market funds, according to the Fed. Throw in short-term Treasuries, and Friedlander reckons retail investors are sitting on nearly $8 trillion in cash.Most of this cash is generating almost no return.

The one-year Treasury yields 0.34%. Tax-free money market funds yield 0.04% on average, according to iMoneyNet.

Friedlander said many investors have begun to find that unacceptable and have moved their money into municipals.

Investors spirited more than $90 billion from tax-free money funds and entrusted $78.6 billion to municipal bond mutual funds last year, according to data from the Investment Company Institute and Lipper FMI.

“Even a continued trickle out of this vast pool of low-yield holdings can provide powerful demand for munis,” Friedlander said.

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