Munis in Holding Pattern Amid Debt Talks

The secondary municipal market found itself in another deadlock on Friday as traders opt to hold off until a debt-ceiling resolution is found on Capitol Hill.

“Everyone is frozen even though Treasuries are up, because of this debacle the federal government is in,” a trader in Los Angeles said. “Until this clears — and everyone is confident it will — everyone is waiting on the sidelines.”

Secondary market trading is usually slow on a Friday, particularly in the summer, and “now it’s even worse with everyone just sitting on their hands,” he added.

Despite a lack of trading, yields did fall a bit. While two-year yields were stuck at a calendar-year low of 0.40%, the 10-year yield was driven three basis points lower to 2.67% and the 30-year yield shed two basis points to 4.35%

Why are rates dropping? That’s easy: a massive rally in Treasuries made tax-exempt valuations particularly attractive. The 10-year Treasury yield fell as much as 18 basis points to 2.77% in the late afternoon before ending at 2.79% — its lowest closing yield for 2011. The two-year Treasury yield firmed six basis points to 0.36% and the 30-year yield dropped 13 basis points to 4.13%.

That rally pushed muni-Treasury ratios to their most attractive levels in months. The 10-year ratio ended the week at 95.7%, its highest since February, while the 30-year ratio ended at 105.6%, its highest since late April.

“Buyers started to reach, yet there still was some hesitation given the risk of multiple muni high-grade downgrades if the U.S. debt losses its AAA-status,” wrote MMD analyst Randy Smolik.

A trader in Dallas, however, said the gain is a bit misleading and doesn’t capture how illiquid the market is.

He said the 177 Aaa-rated public finance issuers that are now on review for downgrade, as published by Moody’s Investors Service Thursday, has scared some traders. “When you print the list off and look at it, it all of a sudden hits home,” he said.

The review involves $69 billion of debt from 162 local governments, 14 housing finance programs, and one university.

The trader said previous actions by Moody’s, like placing pre-refunded munis on notice for possible downgrade, was anticipated, but seeing the best local credits on similar review is chilling.

“If you’re a trader and you’re long a block of Dallas GOs, you must figure your bonds are now worth less than they were,” he said. “It creates so many problems in a market that’s already thinly traded.”

He assumed that lower-rated credits not in the report are all worth less now, too. “The city of Fort Worth, for example, it will be worth less — the whole thing will be worth less,” the trader added.

Confidence was also hurt by the latest municipal fund data from Lipper FMI. Its Thursday report suggested that funds reporting weekly saw net outflows of $129.2 million in the week ending July 27. High-yield funds saw outpouring of $27.7 million and long-term funds lost $226.8 million, while intermediate funds saw a net inflow of $12.8 million.

Meantime, the latest U.S. gross domestic product report showed just 1.3% annualized growth in the second quarter, and revisions slashed first-quarter growth to just 0.4% from a previous estimate of 1.9%.q

That kept the Dow Jones Industrial Average in the red for a sixth consecutive day, dropping 97 points to 12,143. Since the previous Friday, the index has fallen 581 points, or 4.57%.

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