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A New Year for Retail

Retail investors have much less apprehension about the municipal bond market heading into 2010 than they had at the start of 2009, according to market participants.

Just 12 months ago, mom and pop investors faced much of the same uncertainty they harbored throughout a tumultuous 2008, when the subprime mortgage crisis erupted and the auction-rate securities market failed, followed by the collapse of several Wall Street firms and the bond insurance industry.

The 2009 market, however, was soon on the mend and the year ended with a 100 basis-point rally on triple-A general obligation yields compared with 2008. That amounted to a reduction in municipal-to-Treasury ratios from early 2009 of over 150% in some spots, and a slight narrowing of credit-quality spreads.

This year, those improvements — as well as potential increases in tax rates by many states and possible federal tax increases for the upper middle class — will help fuel retail demand for municipals, sources said.

In early 2010, a strong market continues to keep municipal yields relatively lower and the ratios are holding steady. The 30-year GO yield ended at a 4.07% last Friday — after starting the year at over 5% — while the 10-year GO ended at a 3%, according to Municipal Market Data.

Retail bondholders saw the value of their bonds strengthen as 2009 progressed as yields inched down and triple-A GOs due in 30 years fell to a 4.15% yield on Dec. 31, after starting at 5.05% on Jan. 2, 2009.

The ratio is also helping to buoy retail demand as the 30-year municipal-to-Treasury ratio was at a 90.4% as of last Friday, down from its high of 179.7% on Jan. 2, 2009, but still above historical levels, according to MMD.

Although credit spreads between triple-A and triple-B GO bonds are still historically wide, the slight narrowing in 2009 continues to be viewed as a positive by the retail market. For instance, spreads fell to 174 basis points as of Dec. 31, 2009, after beginning the year at 258 basis points on Jan. 2, according to MMD.

These key improvements helped boost record retail demand last year as individuals invested $78.6 billion in municipal bond funds while also withdrawing $92.3 billion from tax-exempt money market funds to escape average yields of less than 0.1% for much of 2009.

Using early bond redemption data as a guide, 2010 looks like it will be a strong year for munis as well, with $38.143 billion expected this month, up from the $30.67 billion in total redemptions in January 2009, according to data from Interactive Data.

With 2010 in its infancy and the nation still in a recession, market participants expect to see continued retail demand for traditional, tax-exempt debt, though they noted that supply might again be somewhat limited due to continued issuance of taxable Build America Bonds.

Although issuers sold $409.13 billion in debt last year — just $20 billion shy of the 2007 record — the BAB initiative eventually brought more than $64 billion of debt to market through Dec. 31,

Given the improvements over the last 12 months, the following six market participants offered their predictions about what trends will drive the retail market in 2010.

Michael Pietronico, CEO of Miller Tabak Asset Management in New York City

“We anticipate that retail investors will continue to support the municipal market in 2010. While retail demand will be more modest in 2010, in our view, it will continue to impress — relative to other investment choices — as the eventuality of higher marginal income tax rates will prove to be a tremendous incentive to consider tax-free bonds.

“Our team views the demand in 2009 to be somewhat distorted due to the significant 'cheapness’ of the tax-free sector relative to Treasuries as the year began. We anticipate that the eventual removal of excess liquidity by the Federal Reserve will begin to weigh somewhat on retail investors’ investment plans and as such a reduction in demand is likely to occur.

“We expect retail investors to enter 2010 with a more defensive outlook which keeps municipal yields on the front end of the yield curve well-anchored and perhaps pulls marginal demand from more aggressive products, such as closed-end funds.”

Chris Mier, municipal strategist at Loop Capital Markets in Chicago

“I expect that interest rates will be slightly higher in 2010, enough to draw the interest of retail. That, along with the possibility of an increase in the top federal marginal tax rate, and a reduction of availability of tax-exempts, could generate a little more interest by retail this year.

With the stock market up big in 2009, retail may view incremental stock purchases as too risky and may come back to the comfort of the municipal market. Working against retail, however, is the continuation of a lot of bad news likely all year long for state and local governments. BABs are taking volume out of tax-exempts on a one-for-one basis with issuers choosing to use BABs whenever they can save relative to tax-exempts.

“Many retail investors will want to stay fairly short on the yield curve because of inflation fears. With BAB yields comparable to the more risky corporate high-grades, the purchase of BABs in an individual retirement account could make a lot of sense to people. We expect registered representatives and financial consultants to use BABs and tax-exempts in a wider variety of high-net-worth investment strategies.”

Sam Ramirez Jr., managing ­director of Ramirez & Co., New York City

“Retail investors have always been the driving force in the tax-exempt municipal bond market and are even more so today. We feel the one situation that could decrease demand would be yields trending to lower levels, forcing retail investors to have yield shock. However, at present levels we see demand remaining strong. Additional trends that support this demand are potential tax increases — which will make the exemption more valuable — as well as the expanded use of the retail order period for new issues.

“The Fed has made it clear that it does not intend to raise rates until the unemployment rate shows signs of improvement. Strategies we are using in this environment include more of a barbell-type strategy and, for well-established laddered portfolios, a similar strategy of a concentration on shorter and longer maturities, avoiding the three-to-15 year maturities. When the Fed tightens, we are expecting the short end of the yield curve to trade off more than the longer end, and in this scenario, a barbell strategy is preferable.

“With the growth of the issuance of taxable municipal bonds and BABs we are seeing a trend of growing acceptance of the asset class for retail in retirement accounts. The supply of tax exempts will be decreased slightly due to BABs, and this could create a scenario where we see more demand than supply, which should cause the municipal asset class to outperform other fixed-income asset classes in 2010.”

John Mousseau, vp and portfolio manager at Cumberland Advisors, Vineland, N.J.

“We think the retail investor will ­continue to be important this year. We have seen more flows into tax-exempt bonds at higher levels than the stock ­market. We think many investors looked into the ­equity abyss of March and ­correctly reasoned that they could not sell into that mess. The fact that equities have rebounded 35% to 60% since March is allowing retail investors to reallocate more money to bonds now.

“BABS will continue to be an important driver in reducing tax-exempt supply, while asset allocation and higher tax assumptions are boosting demand. I see retail investors adding BABs to their IRA and Keogh accounts as BABs are expanding the concept of municipal bonds as an asset class.

“If people start to discount a higher marginal federal tax rate into computing taxable-equivalent yields it should boost demand, and push people further out on the curve since higher yields produce greater taxable equivalent yields.”

Michael Davern, vp and director of ­municipal managed money at Nuveen Asset Management in Chicago

“There’s a lot of concern about rising rates and that impacts investor demand, but even though we are in recession, retail will be no more cautious than they are at any other time. Overall, demand should remain strong as investors look for asset classes that seek to conserve principal and generate consistent tax-exempt income.

“This will be especially important because many states are expected to increase tax rates to help balance budgets and the Bush tax reforms are due to sunset after 2010. In addition, some budget proposals by the Obama administration may result in tax increases for the upper middle class.

“Supply will likely continue to be constrained with the effects of the recession and the availability of taxable Build America Bonds. If retail already owns bonds, there will be strong demand for, and scarcity of, what they own, and that will push prices up. If they are looking to get involved, the supply constraint could make it difficult to find bonds and more expensive.

“Municipal bonds have moved toward a more normal relationship with Treasuries. These relationships may tighten further in light of pending tax increases. However, many nontraditional municipal buyers have disappeared and often only retail investors are providing liquidity to the market.”

Nathaniel Singer, managing director at Swap Financial Group, South Orange, N.J.

“With respect to the short end of the tax-exempt curve, we have come a long, long way. Over the past year, we have seen the opportunity to invest at 200% of taxables for five-year, triple-A rated tax-exempts and now we see yield ratios closer to 65%. Even if tax rates go higher — the anticipation of which appears to be driving money into tax-exempts — municipals still have to be considered 'rich’ at the front end.

“Money market yields might as well be considered to be zero. If the belief is that a resurgent economy will cause yields to start going higher — and the Fed embarks on an asymmetric directive — we may start to see a reallocation of money out of short to intermediate tax-exempt fixed income and into the equity market. This may provide a challenge to the tax-exempt market, and retail investors, if volume continues to be heavy into 2010.

“BABs will have the greatest impact on long maturities, which is not the focus for the vast majority of retail investors. If anything, BAB issuance may cause a flattening of the muni yield curve, which will further dissuade retail from any sort of extension trade as an alternative to crossing over to equities.

“With respect to credit, my bet is that 2010 will mirror 2009 — a lot of talk about the impact of the economy on muni credits, but limited impact in terms of retail investment.”

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