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BABs Shrank in July, But Volume Still Rose

JUL 30, 2010 8:19pm ET
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Issuance of Build America Bonds fell precipitously last month, but overall volume still managed to outpace market issuance in July 2009, according to preliminary data from Thomson Reuters.

Total issuance in July advanced 5% compared to the same month last year, as 945 new issues hit the market totaling $27.4 billion. That brings total municipal volume in 2010 to $232 billion.

Despite the July increase, last month was historically weak for volume. Last year aside, issuance in the month was lower than any July in the past half-decade. And not by a small margin either: in July 2008, issuance was almost $10 billion greater.

One culprit for the slow issuance was Build America Bonds, the taxable asset that offers issuers a 35% interest cost subsidy. Just 84 BAB deals worth $5.9 billion were issued in July, the smallest number of issues and the lowest amount seen since July 2009.

Justin Hoogendoorn, managing director at BMO Capital Markets in Chicago, said the low issuance of BABs was related to spreads widening out against Treasuries during the global flight-to-quality over the last several months.

The benchmark 10-year ­Treasury yield fell 111 basis points from 3.97% in early April to 2.86% on July 21. BABs couldn’t keep up: over the same period, BAB spreads widened from 170 basis points to more than 240.

“The spreads in BABS are pretty attractive right now from an investor’s standpoint, but from an issuer’s standpoint — which will create the volume — it’s a good reason at the margin to come in with tax-exempts,” Hoogendoorn said.

Two-thirds of issuance by dollar amount, and 699 of 945, or 74%, of transactions were tax-exempt in July, a total of $18.2 billion. That marks a 15% decline from the same month last year, reflecting how the broad growth of Build America Bonds — even in a slow month ­— has limited tax-exempt supply.

BAB volume helped taxable issuance increase 85.7% last month compared to July 2009. But the comparison is misleading because BABs first hit the market in April 2009 and remained in their infancy for several months.

Since BABs’ inception borrowers have come to market with 1,597 deals totaling $121.9 billion. While BABs were less attractive to issuers because of spreads widening, tax-exempt coupons tracked closer to Treasury yields and as a result became more appealing.

The Municipal Market Data’s benchmark 10-year triple-A yield ranged from 2.57% and 2.76% in July, averaging 2.63%. The 2.57% level, hit on July 21 and maintained for the remainder of the month, is the lowest yield in more than 30 years of data.

It’s also 59 basis points down from the calendar year high of 3.16% in early April. Despite falling yields, however, on a relative basis munis have become cheaper: the 10-year muni-to-Treasury ratio from early April to late July moved up as much as 10 percentage points to 90%.

Jay Murphy, managing director at Stone & Youngberg in New York, noted buying tends to dry up when certain threshold levels are passed, such as 10-year muni rates dropping below 3% or 20-year rates falling below 4%.

But, he said, BAB issuance “has stolen a good chunk of the volume” out of tax-exempts. The lack of supply in traditional munis has allowed yields to fall without buyers balking. “The uncertainty of equity markets have kept people investing in munis,” Murphy added.

Chris Holmes and Alex Roever, fixed-income analysts at JPMorgan, wrote in a  research note that strong inflows into tax-exempt mutual funds have also contributed to pushing intermediate yields lower.

Refunding issues were another factor in the slow issuance. While new-money deals in July rose 19% to $20.4 billion compared to a year ago, refunding volume fell 15.8% in the same period.

The climate for refunding was favorable earlier in the year mainly due to the steep municipal curve and lower muni-to-Treasury ratios. More recently, falling Treasury yields caused those dynamics to change.

The 10-year muni-to-Treasury ratio ranged from 84% to 94% last month, compared to less than 80% earlier in the year before Treasury yields started falling.

In an advance refunding, the proceeds typically are used to buy Treasury securities that are placed in escrow to pay interest on the refunded bonds until they can be called. When Treasury rates fall, the interest gained in escrow is lower, making the transaction less appealing.

Murphy said the fall in Treasury rates is probably a big piece of why refunding volume declined. “It’s not as though rates just jumped off a cliff — they’ve been marching their way down,” he said. “Negative arbitrage is eating into savings more than issuers would like.”

In contrast to July, year-to-date refunding is up almost one-fifth. Murphy said issuers who wanted to refund may have already done so earlier, leading to a feeling of “refunding burn-out.”

Among sectors, changes in volume were heavily lopsided in favor of general purpose bonds, which shot up 88.6% in the month compared to July 2009.

Education and transportations bonds, the second- and third-largest sectors, were roughly flat with $5.8 billion and $5.3 billion issued in the month, respectively.

Other sectors mostly tumbled. Health care bond volume fell 68.9% to $720 million, housing volume slid 38.9% to $484 million, and public facilities volume declined 56.8% to $537 million.

Hoogendoorn said the leap in general purpose issuance explains why competitive issuance rose 68.9% in July versus the same month last year.

“Those are generally more plain-vanilla,” he said. “If you have health care or utilities coming to market, there’s more of a story behind it, so those will more likely come to the negotiated market to be able to relay the story and get investors comfortable.”

Hoogendoorn noted that many states came to market last month, most of which were competitive. These included a $900 million BAB deal from Illinois, a $712 million offering from Washington, and a $222 million issue from Maryland.

Bond insurance continued to play a minor role in July. Just 138 deals worth $2 billion were insured in the month, reflecting a market share of 7.2%. Insurance year to date fell 37.6% compared to the same period last year, to $15.7 billion.

Total issuance looks likely to remain light over the next month. The Bond Buyer’s 30-day visible supply index on Friday was a modest $7.34 billion.

Holmes and Roever predicted in November that total 2010 supply would be $415 billion. In mid-July they said supply had lagged about $20 billion below that forecast. However, they refrained from adjusting their prediction.

“We suspect that the tepid risk climate between April and June led some borrowers to postpone borrowing plans,” they wrote. But in the coming months, borrowers could “flood the taxable market” as the 35% BAB program is scheduled to expire at year end and proposals to renew it offer a lower subsidy for 2011 and beyond.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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