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The Long-Term Question Still Lingers

FEB 9, 2011 6:58pm ET
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As the expiration of the Build America Bond program loomed last year, the market was wracked with uncertainty about just who was going to buy long-term tax-exempt bonds. Thanks to the drought of new municipal bond issuance in 2011, the market is still wondering.

It is far from clear what will happen when municipalities finally come to market with a hefty, or even normal, amount of long-duration tax-exempt supply. Few market participants believe the crossover buyers who have somewhat buoyed the market amid a small amount of municipal supply so far this year can sustain the market permanently. And wealthy retail investors, who form the cornerstone of demand for municipals, have never liked long maturities.

It may simply be that there is not enough demand in the tax-paying universe to absorb ­municipalities’ borrowing at the rate established the past few years. Some of the more dire voices in the market believe that without another clever structure to shorten the duration of tax-exempt borrowing or siphon it into another market, governments face a stark choice: borrow a lot less, or pay a lot more.

“They have to get to a distressed level to get supply done,” said Peter Coffin, founder of Breckinridge Capital Advisors. “If an issuer really needs capital, it’ll sell bonds at a distressed level. But that’s crazy.”

The muni bond market suffers from a fundamental disconnect. In order to raise money to build highways, refurbish schools, and deliver water and power, municipalities need to sell long-term tax-exempt debt.

At the same time, the universe of investors interested in buying long-term tax-free paper is naturally limited.

Rich retirees trying to fund a comfortable lifestyle with fixed income are too averse to inflation to stretch out much beyond 10 years, regardless of yield.

Banks and property and casualty insurance companies are generally trying to match assets with liabilities with durations nowhere near three decades.

Pension plans have longer-duration liabilities to match, but tax-free interest payments are not as palatable to them because they do not pay taxes on their investment income anyway.

Municipalities’ bankers and financial advisers have spent the past decade figuring out ways around selling long-duration tax-exempt bonds, given the dearth of buyers.

Their solutions generally involved dressing up long-term debt in short-term clothing, using structures like auction-rate securities or variable-rate demand obligations.

More than a fifth of municipal ­borrowing in most years for the last decade was in these structures, which behave like short-term debt and are therefore salable to short-term investors who would never consider buying long-term tax-free debt.

The $200 billion municipal ARS ­market froze in 2008, and issuance in the $400 billion tax-free VRDO market has contracted substantially as governments have soured on paying for the bank ­guarantees and swaps these deals require.

Leveraged hedge funds also digested significant long-duration supply in the last decade, until the financial crisis waylaid their hedges and the trade imploded.

The latest experiment — BABs — authorized municipalities to sell federally subsidized taxable bonds. This enabled the issuers to ship their long-term debt into the taxable market, which has a far broader base of long-duration buyers than the tax-exempt market.

Municipalities sold $187 billion of BABs during the life of the program. Because the average BAB maturity is 28 years, the taxable program was poaching significant long-term supply out of the tax-exempt market.

With BABs lapsing at the end of 2010, the long-term tax-exempt market was set to lose its final pillar.

The extraordinary expansion in annual municipal issuance over the past decade — the market grew an average of 6.8% a year — was facilitated by a number of structures with varying degrees of leverage and exoticism, all of which have either vanished or shrunk too much to be a significant factor anymore.

Municipalities thus entered 2011 facing a daunting question: what happens when you try to force long-term tax-free bonds onto a market that doesn’t really want them?

So far, governmental issuers have largely chosen to refrain from borrowing rather than find out.

“The very light supply that we’ve seen so far in 2011 has been a significant offset to that discovery,” said Phil Villaluz, head of municipal research and strategy at Sterne Agee. “It’s too early to see right now how that’s going to play out.”

Municipalities sold $12.2 billion of bonds in January, the lightest monthly total in 11 years. The calendar remains light, too, with $8.4 billion scheduled to be sold over the next 30 days, based on The Bond Buyer’s visible supply.

Though issuance was expected to be light because the BABs expiration pulled supply forward into late 2010, the stress in the muni market is clearly keeping some issuers on the sidelines.

In a report earlier this month, Citi estimated that at least $2 billion or $3 billion of issuance that otherwise would have come to market in January was postponed because of the market stress.

Regardless of whether the past few months are merely a technical deviation or expose an incurable structural deficiency in the $2.8 trillion muni market, most participants believe yields would need to rise further if municipalities tried to issue a more typical $7 billion or $8 billion of weekly supply for two or three weeks.

Meredith Whitney-style prognostications have scared investors out of the market. Muni bond mutual funds have reported almost $36 billion of outflows in the past three months, according to Lipper FMI.

“I’m not sure that the retail interest is sufficient enough right now to absorb a normal to above-normal supply,” said Hugh McGuirk, head of municipal investments at T. Rowe Price. “We have a finite amount of demand, and the supply appears to be kind of regulating to how much demand there is.”

Breckinridge’s Coffin believes it’s not as simple as buying time until retail comes around, or correcting rates higher to tempt retail into the long end of the tax-exempt curve.

Coffin argues the market weakness is not a temporary condition. The market is not wheezing because of Whitney’s appearance on “60 Minutes,” or because of scary headlines, or because retail is waiting to see more enticing yields. The market is wheezing because fundamentally, it lacks an adequate foundation of demand for long-duration tax-free paper.

After all, scary headlines abounded for many months before municipals started selling off. The truth is, the tax-exempt market was doing fine until it became apparent the BAB program would expire, raising the prospect of long-duration tax-exempt supply, which the market simply does not have the capacity to absorb a lot of, Coffin said.

Wealthy retirees don’t drool over high yields. They like safe, dependable income that’s not overly vulnerable to inflation. There is simply not enough demand from the retail community to support the kind of long-term volume municipalities were able to wring out of VRDOs, ARS, and BABs.

“More retail might be enticed out longer if muni yields get higher, but inherently it’s just not a big enough pool,” Coffin said. “I don’t think you’ll ever be able to get enough of them. Our market outgrew their capacity.”

It’s true that retail was absorbing long-term tax-exempt supply before VRDOs, ARS, and BABs became so dominant, but that was when municipalities were borrowing more like $200 billion a year — not the record $432 billion of issuance the market absorbed last year.

Adam Mackey, managing director of municipal fixed income at PNC Capital Advisors, also subscribes to the structural-deficiency theory. Considering tax-free bonds only make the most sense to the wealthiest 2% of Americans, the municipal market is mostly closed to the rest of the world. Governments will have to take a look at the nature of munis, Mackey said, and evaluate whether it makes sense to keep letting tax-exempt yields reach 100% of Treasury yields to lure in crossover buyers.

“Longer tenors — there’s just nowhere for that stuff to go,” Mackey said. “We need to kind of reconstitute what the muni market is. … This is certainly an inflection point, where we need to reconstitute again, where we need to find a point where muni debt is going to clear.”

Most market participants appear to agree on at least one thing: the hedge funds, life insurance companies, and other crossover buyers that have been doing most of the buying in 2011 are not the solution.

These buyers will only stay in the market so long as tax-exempt rates are attractive relative to taxable rates, providing a natural check on just how much support they can provide. In other words, crossover buyers only buy when yields reflect stressful conditions.

“I worry about the longevity of the crossover buyer,” McGuirk said. “If they’re looking to make a quick pop and get out in a month, then that doesn’t really help us.”

George Friedlander, municipal strategist at Citi, thinks more sizable supply might actually help the market, if only because it would provide more information about what it takes to sell tax-exempt bonds.

“The muni market has a history of abhorring a vacuum of new issuance in a given sector because it leaves participants uncertain as to what the 'clearing yield’ would be when supply comes back,” Friedlander wrote in a report last week. “Many times in the past, improved price discovery has actually provided support for sectors where new-issue supply starts back up.”

As long as crossover investors remain the primary buyer of municipal bonds, though, he expects to see credit spreads widen when supply picks back up.

The reason for this is that crossover buyers prefer to buy only the highest-grade municipals.

While hedge funds and insurance companies for now may be able to absorb double-A and triple-A municipal supply, issuers rated single-A or lower would likely have a much tougher time finding a home for their debt.

“We aren’t yet sure that there will be sufficient demand for medium-quality paper without an additional yield adjustment once the calendar rebounds,” Friedlander said.

“With the exception of certain parts of the high-yield sector that are receiving support from hedge funds, there is very limited support from crossover buyers below [AA], and we do not expect that to change appreciably as the calendar moves back toward more normal levels.”

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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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