Monday's Market

Supply Drought Masks True Trading Conditions

The municipal bond market has slipped into a disquieting equilibrium in which investors don’t really want to buy munis and municipalities don’t really want to sell them.

Don’t be fooled by the tranquility showing up in the Municipal Market Data numbers the past few weeks, with yields down 15 basis points on the year and 30-day annualized volatility on the 30-year below 10% for the first time since November.

Lurking beneath these numbers is a scary unknown: municipalities can cut back on raising money in the bond market temporarily, but what happens when they ultimately need to borrow money?

The stark reality is that it’s not clear who, if anybody, wants long-term tax-free bonds. A two-month supply drought is only postponing the day when the market finds out.

When asked whether the traditional retail investor might be interested in long-duration tax-exempt paper, a trader in New York responded: “Not at current yields.”

“If the supply comes back I think it will probably be a little difficult, because you don’t have the buyers that you did before,” said Vincent Harrison, who manages eight municipal bond mutual funds with about $1.1 billion of assets for Dupree Funds.

State and local governments have responded to the evaporation of demand for their long-term debt by giving the market what it wants: very little.

Municipalities sold just $12.75 billion of bonds in January and $16.16 billion in February. Adjusting for inflation, that was the lowest two-month total since 1995.

This week, municipalities are scheduled to sell $3.5 billion of bonds, after a $2.9 billion slate last week, according to Bond Buyer and Ipreo data.

The biggest deal by far this year has been Illinois’ taxable $3.7 billion pension bond sale. No other deal has come close to $1 billion.

Scarcity has bolstered the market, regardless of credit concerns, incipient inflation, tax cuts, rising Treasury rates, or any other obstacles facing municipal debt.

Nothing on the calendar this week alters the low-supply calculus much: a $631 million New York City deal, a $485 million Maryland sale, a $355.1 million Georgia Road and Tollway Authority offering, and a $250 million Puerto Rico pricing.

This can only last so long. Nobody we have spoken to thinks the contraction in borrowing corresponds with a contraction in municipalities’ needs to repair highways, build middle-school gymnasiums, and sanitize the water from flushing toilets.

A majority of respondents to an RBC Capital Markets survey last month thought that municipalities would not cancel or postpone capital projects because of the nap the market’s been taking.

This is not a matter of waiting out a rough patch. There’s no rough patch to wait out — it’s a structural deficiency. Yields are simply not high enough to tempt investors into long-term tax-exempt debt.

Eventually, municipalities will have to test the market. When that happens, the current MMD numbers will prove too low. The only question is how much higher the yields will have to be corrected.

“It still isn’t clear how the market would handle heavier long-term supply, apparently lacking sufficient 'natural’ buyers for long-term tax-exempts,” the Citi municipal strategy team, led by George Friedlander, wrote in a report last week. “There continues to be a severe shortage of end-use buyers for long-term munis, and that shortage may lead to a substantial upward correction in yields when the supply of new, medium-quality revenue bonds, in particular, rebounds up toward more normal levels.”

In other words, governments’ willingness to refrain from borrowing when the market is under stress masks the extent of the stress. If we could see the underlying reality, we would know it is a great deal more dire than it seems.

The grand majority of the world’s investable dollars are held by entities that either have tolerance only for short or intermediate duration or do not pay enough U.S. taxes to warrant holding tax-free bonds.

Municipalities have witnessed poor demand for their paper, and they have not risked upsetting the Street by forcing bonds onto an unwilling market.

Over the next few months, they’re going to have to. When that happens, well … you remember the fourth quarter.

History, unfortunately, offers little meaningful guidance on how the market will react when this day comes.

The municipal market’s dirty little secret is that it has never sold long-term tax-exempt bonds to retail investors in the quantities it might need to now.

A variety of gimmicks and programs, some more exotic than others, have succeeded the past few years in siphoning long-term tax-exempt supply away from the distribution channels that feed retail investors. Build America Bonds were only the most recent incarnation. Before that, municipalities tried disguising their long-term debt as auction-rate securities or variable-rate demand obligations. Leveraged hedge funds also played a big role in absorbing long-term supply in the last decade.

Those are all gone, or at least severely diminished. The last time retail investors were asked to swallow the bulk of long-term tax-exempt supply, total issuance was far smaller than it was last year.

That’s why the current equilibrium should not be comforting at all. Unless the market invents a new diversion for long-term tax-exempt supply, municipalities face higher borrowing costs than they have in a long time.

Somewhere underneath the market tranquility is an expensive new reality the market will eventually have to adjust to. Waiting a few months to find out what it’s like will not make it any cheaper.

“There hasn’t been supply of long municipal bonds for a while,” a trader in New York said. “Once you have a consistent supply of new issue we’ll see a little bit of cheapening.”

The primary market didn’t offer much in the way of discovery Monday, thanks to only a handful of deals being priced.

The biggest bond pricing came from the Unified School District No. 229 in Johnson County, Kan., which runs 32 schools with about 21,000 students.

The $32 million competitive deal, advised by George K. Baum, priced at a true interest cost of 3.2%, with a syndicate led by UBS Financial Services the winning bidder.

The longest maturity, which was 2030, priced at a yield of 4.13%, about seven basis points lower than the triple-A scale’s close on Friday. Moody’s Investors Service rates the deal triple-A, while Standard & Poor’s rates it AA.

The district finances a roughly $140 million operating budget mainly by charging property taxes on $2.34 billion of real estate. About 40% of the budget comes from a mix of state and federal aid.


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