Tuesday's Market

Munis in Stasis as Issuers Stay on Sidelines

The supply drought that has prevented the municipal yield curve from steepening further is a drought better measured in years than in dollars.

State and local governments’ willingness to wait out turbulent market conditions has left the Street craving “price discovery” — which could be accomplished by an onslaught of long-term tax-free bond issuance that forces underwriters to find the right yield that attracts buyers.

Without this price discovery, the municipal credit market is caught in stasis. Long-term tax-free yields are too low to magnetize investors. Municipalities don’t want to upset the Street by selling bonds and shocking rates higher. So, yields stay low and investors stay home.

The 10-year triple-A municipal bond yield closed unchanged at 3% Tuesday, according to the Municipal Market Data scale. This was the second-straight day of no change in yields for the 10-year.

A trader in New York said this week’s $3.5 billion supply is not going to be enough to push yields higher to rekindle retail interest.

“I don’t expect it to be that wave of new issuance that we need to help cheapen up the market,” the trader said. “I don’t think it’s going to help our supply issue.”

The supply shortage is generally described in par amount. Municipalities sold $28.91 billion of bonds the first two months of the year, compared with $46.5 billion the first two months of last year. State and local governments sold $117.3 billion of taxable Build America Bonds last year, issuance that otherwise would have to filter through tax-exempt channels.

In fact, the face value of the bonds that are yet to be sold is a poor measure of just how much “discovery” the Street is yet to experience.

The buy side of the muni market is not averse to high par value; it’s averse to long duration. Any municipality willing to pay the bank-liquidity costs to issue variable-rate demand obligations would find ravenous buyers in the $325 billion, tax-free money market fund industry.

If and when supply ramps up, it will not be the par amount that’s difficult to absorb. It will be the maturities — the “bond years,” in market vernacular.

“Our demand is definitely in the front end of the curve,” said Jeffery Timlin, a portfolio manager at Sage Advisory Services in Austin.

The 30-year triple-A yield currently exceeds the 10-year yield by almost 180 basis points, the steepest 30-10 curve since February 2009. The slope of this portion of the curve tells an important story.

The municipal research team at Citi, which is led by George Friedlander, reckons that the average maturity on tax-free bonds this year will be much longer than it was last year.

The taxable market absorbed the brunt of 2010’s bond years. The average maturity on a Build America Bond is more than 28 years, according to a Wells Fargo index tracking the sector.

After the expiration of the BAB program at the end of last year, no such buffer exists this year. Municipalities financing capital projects with long and useful lives will need to sell tax-free debt with maturities out past 20 years. Those are the deals that are yet to test the market.

“We’ve been sort of skating, to a degree, on thin ice,” a trader in California said. “If there was a big size [on the long end], it would have to take a lot of yield to get it done.”

Citi’s forecast for tax-exempt issuance this year is roughly unchanged from last year’s $275 billion. What is different is that the tax-free issuance this year will have longer maturities and impose more bond years on a market that has always hated — and given the possibility of a rising interest-rate environment, especially hates now — duration.

“The total amount of bond years the tax-exempt market will have to absorb in 2011 is still likely to be up fairly sharply,” the Citi team wrote in a report last week. “The average maturity will be far longer than it was in 2010, when Build America Bonds absorbed a very large proportion of supply in maturities 10 years and longer.”

Tolerance for duration seems a particularly relevant topic now, with inflation-protected Treasury securities implying a rate of inflation of more than 2.5% over the next five years — the highest implied rate since July 2008.

Considering the duration-wave yet to come, it is worth exploring why the municipal market hates long maturities.

Municipalities found takers among foreign buyers and others for long-duration debt in the taxable market last year. Why should the tax-exempt market struggle more with long maturities and high interest rate sensitivity than the taxable market?

There are really only a handful of demographics that buy tax-free debt in the U.S. According to the Federal Reserve, banks, insurers, households, and the types of investment vehicles typically associated with retail investors hold 95% of the $2.86 trillion of outstanding municipal debt.

Each of these categories hates duration for its own reason. We plan to visit the source of duration-aversion for each type of investor over the coming days. Let’s start with property and casualty insurers.

The $1.4 trillion P&C insurance industry holds $370 billion of municipal bonds, or about 13% of outstanding state and local government debt. Because insurers pay income taxes, more than a quarter of the industry’s assets are in munis.

The property-casualty business model is to collect premiums in exchange for promising to pay out a certain amount given a certain event, such as a car crash or a tree falling on your house.

Insurance companies generally spend all the premiums they collect administering claims, in the long run.

Their profits come from investing the premiums and earning income from the time they collect the premium to the time they pay it out.

This strategy essentially requires estimating when the companies will pay out their claims based on actuarials, determining the duration of those estimated future payouts, and then constructing an investment portfolio whose duration matches the liability duration. This process is known as immunization.

The duration of property insurers’ liabilities mostly keeps them out of very-long-term tax-exempt paper.

While insurance companies do not disclose the estimated duration of their liabilities, they do disclose the duration of their fixed-income portfolios using a measure that prices sensitivity to interest rates.

The average P&C insurer’s fixed-income portfolio has a duration of less than 4, according to data compiled by SNL Financial. The five biggest insurers’ bond portfolios all have a duration no higher than 4.

By contrast, the $1.3 trillion S&P/Investortools Municipal Bond Index, which essentially tracks the entire universe of rated municipal debt, has an average duration of 6.8. Vanguard’s $6.9 billion long-term tax-free fund has an average duration of 7.4 — well in excess of virtually all property insurers’ duration tolerance.

What’s more, some of the biggest insurance company investment portfolios have been shortening their duration. Travelers Cos., for instance, which manages a $39.5 billion municipal portfolio, shortened its fixed-income investment duration to 3.9 last year, from 4.2.

Allstate, by the way, which also mentioned duration-shortening in its annual report, dumped $4.9 billion from its tax-exempt portfolio last year.

Meanwhile, in the primary market, the biggest deal to price by a long shot was New York City’s $686 million refunding bond sale. The $445 million tax-exempt portion of the deal priced with yields ranging from 0.3% to 3.4%, for maturities ranging from 2011 to 2020.

JPMorgan won a $166.9 billion taxable component of the deal with a bid reflecting a 1.65% true interest cost for the city, which is rated AA by Standard & Poor’s and Aa2 by Moody’s Investors Service.

Piper Jaffray & Co. was the winning bidder on a $79.4 million taxable component, at a rate of 0.3%.


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