After a wild fourth quarter rife with technical pressures and illiquidity, it turns out municipals mostly may have simply been obeying their old master: Treasuries.
Municipals endured a rough final quarter of 2010, snakebit by rampant supply and credit fears. The looming expiration of the Build America Bond program raised the specter of substantially more long-term tax-exempt supply, and Meredith Whitney appeared on 60 Minutes to predict “hundreds of billions of dollars” of municipal bond defaults.
For all the talk of headline risk and supply pressures, though, municipals’ performance in the final three months of 2010 looked suspiciously like Treasuries’ performance in the final three months of 2010.
The 10-year Treasury yield, for instance, spiraled up 79 basis points in the fourth quarter as brighter economic data and the extension of the Bush tax cuts dampened the appeal of safe havens.
The 10-year municipal yield, according to the Municipal Market Data triple-A scale, jumped 78 basis points.
“A lot of the movement that you saw in the muni market was based on the Treasury market sell-off,” said Rob Novembre, managing director at Arbor Research and Trading. “I didn’t see this sell-off as necessarily isolated to the muni market. I [see] it more as the muni market following the Treasury market as it sold off.”
The truth is that the municipal sell-off in the fourth quarter was actually two sell-offs.
For maturities 10 years and in, the jump in yields was mainly a reflection of what happened in the Treasury market — garden-variety Treasury-mimicry.
For longer maturities, anticipated supply pressures from the expiration of BABs exerted further upward pressure on yields. While Treasuries explained part of the increase in long-term muni yields, supply pressures led to further municipal curve-steepening not reflected in long-term Treasury yields.
“There was a relationship between what happened between Treasuries and municipals at the short end, but that broke down as you got further and further out in maturity,” said Michael Brooks, senior portfolio manager at AllianceBernstein. “The further out you went in terms of maturity, the bigger the increase in interest rates” relative to Treasuries.
In the fourth quarter, three-year triple-A municipal yields rose six basis points less than three-year Treasury yields, and five-year triple-A muni yields rose 27 basis points less than five-year Treasury yields.
Fifteen-year municipal yields, meanwhile, rose 28 basis points more than 15-year Treasury yields. Twenty-year muni yields rose 40 basis points more than 20-year Treasury rates, and 30-year muni yields rose 31 basis points more than 30-year Treasury yields.
Treasuries explain a significant portion of the shift for the entire curve. However, munis’ outperformance for short maturities and underperformance for long maturities highlights the influence the expiration of BABs had on the long end, but not the short end.
The supply BABs siphoned into the taxable market has been overwhelmingly comprised of long-maturity bonds. The average BAB maturity is 27.5 years, according to a Wells Fargo index.
Of the roughly $187.4 billion of BABs that were issued, only about $20 billion matures in the next 10 years, according to Bloomberg LP.
As the fourth quarter unfolded, it certainly felt like yields were being driven by idiosyncratic factors unique to the municipal market. The secondary market became very illiquid as dealers were reluctant to take on supply given the prospect of greater tax-exempt issuance. This set of circumstances occurred just as state and local governments were ramming mountains of new debt into a market that was having trouble finding buyers.
Municipalities sold $133 billion of debt in the fourth quarter, according to Thomson Reuters, the second-highest quarterly total in history. Moreover, this debt came in highly concentrated batches. At a time when it was hard to find a bid anywhere, municipal issuers sold $14.69 billion of debt during the week ended Nov. 19, the third-highest weekly issuance in eight years, according to Bloomberg.
Other weeks in the fourth quarter featured issuance of $13.19 billion, $12.11 billion, $11.49 billion, and $11.33 billion. Of the 20 heaviest weekly volumes since the beginning of 2003, five were in the fourth quarter of 2010.
Compounding matters, investors began to withdraw cash from municipal bond mutual funds in the thick of all this. Mutual funds reported almost $16 billion of outflows the last two months of the year, according to Lipper FMI.
While taxable bond mutual funds reported some outflows in the fourth quarter, they were extremely modest compared with municipal outflows.
Yet with all these headwinds facing municipals and not Treasuries, the seven-to-10-year Treasury returned negative 4.22% in the fourth quarter, according to a Standard & Poor’s and BGCantor/Market Data index. The Standard & Poor’s index tracking municipal bonds for the fourth quarter showed an identical return of negative 4.22%.
“Generally speaking, I think the Treasury sell-off was as big a driver if not more” than the BABs expiration, said John Derrick, director of research at U.S. Global Investors. “It was largely Treasury-driven, and then the BABs issue on top of that. The supply issues kind of compounded it.”
Market participants have regarded the relationship between municipals and Treasuries warily for years now. The once-dependable correlation between the two broke down completely during the financial crisis, and has been spotty ever since.
There are times when the two move in tandem, though, and most agree Treasury rates are still a primary driver of muni rates over long periods of time.
“On a day-to-day basis, I don’t think it’s that relevant,” Tom Spalding, senior investment officer at Nuveen Investments, said of the muni-Treasury relationship. “Week-to-week it becomes more relevant, and then over time it becomes very relevant.”