Tuesday's Market

Fear Trade Bolsters Munis

The panicked aftermath of last week’s earthquake in Japan buttressed the municipal bond market on Tuesday as investors sought the protective sanctuary of high-quality dollar-denominated bonds.

The so-called risk-off trade is back after a brief hiatus. The S&P 500 Index slipped 1.1% on Tuesday. The 10-year Treasury yield dipped five basis points to 3.31%, the lowest yield since Jan. 13.

Broadly speaking, this was a plus for municipal debt. Although municipals are by no means lumped into the “risk-free” category with U.S. federal government debt, their well-demonstrated correlation with Treasuries over time means municipal debt generally gets a boost in times of fear.

The 10-year triple-A municipal bond yield sank seven basis points on Tuesday, according to the Municipal Market Data scale, while the 30-year yield dropped four basis points.

“Whenever the Treasury runs like this, there’s always a flight-to-quality bid and all the high-quality municipals are following suit right now,” a trader in San Francisco said. “It’s standard stuff.”

The financial crisis solidified Treasuries’ status as the world’s ultimate safe haven, and subsequent periods of fear such as the Eurozone debt crisis have continually fortified this dynamic: when investors are scared, they buy Treasuries. Municipals usually follow, though often at a lag and to a more muted extent.

The tax-free bond market’s friendship with fear is proved by an inverse correlation between municipal bond yields and the Chicago Board Options Exchange’s Market Volatility Index, a gauge of market volatility better known as the VIX.

The VIX measures how much it costs to insure the S&P 500 against swings in value, thus providing a quantification of investors’ concerns about market volatility.

This concern was prevalent yesterday, as the VIX surged almost 13% to its highest level since September. History shows that municipals tend to do well amid this kind of fear.

The 30-day correlation between changes in the Municipal Market Advisors’ 10-year triple-A yield and the VIX is negative most of the time, generally at about minus 0.3. In other words, when markets grow turbulent, municipal yields go down.

The flight-to-quality bid on Tuesday helped to firm a municipal market that has become rather jittery about just how much demand there is for tax-free debt.

Municipalities may very well close out the first quarter having issued less than $50 billion of bonds. Even amid such a sickly supply, one trader in California said the market until this week has been “pushing out at the edges of where we could get things done.”

The dip in yields helps to solidify demand a little.

“I don’t see a strong broadening out of the market, but I think we will get a little bit more demand in play here,” this trader said. “The headwinds are still too great for a real broadening out in municipals at this point.”

The flight to safety was more ­pronounced earlier in the day. The bid retrenched a bit later in the afternoon, after the Federal Reserve adopted a modestly more optimistic assessment of the economy.

The Fed shocked nobody in deciding to keep its target for short-term interest rates slightly north of zero. The pricing of interest rate futures contracts coming into today suggested zero probability of a rate hike at this meeting.

Still, the Fed eased back on some of the cautionary language that had accompanied previous statements, suggesting the possibility of a rate hike at some point on the visible horizon.

“On balance, there appears to be slight shift in the policy statement towards the inflation risks we see as more substantial,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott, wrote in a report. “The risks have clearly flipped from those of deflation to those of inflation.”

LeBas now expects the Fed to raise its target for interest rates in April 2012.

Joseph LaVorgna, chief U.S. economist at Deutsche Bank, expects a rate hike in the fourth quarter of this year. He pointed out that the Fed’s statement noted firmer economic footing, and omitted previous language about constrained consumer spending.

Wake County

You’d think the market would be getting sick of mid-sized, triple-A rated deals by now, but thankfully for Wake County, N.C., they’re still moving off the shelves.

The county, which is rated triple-A across the board, commanded strong bids in the competitive auction for its $116.8 million general obligation bond sale on Tuesday.

JPMorgan won the deal, with a bid representing a true interest cost of 3.36% for a series of bonds with an average life of 10 years. The deal’s maturities are spread out more or less evenly over the next 20 years.

The issue actually priced at lower yields than MMD’s triple-A scale at some of the shorter maturities. The five-year maturity priced at 1.68%, versus the closing triple-A yield of 1.69%. The 10-year piece priced at 2.92%, also a basis point lower than the scale.


We’ve been running through a category-by-category analysis of the buy-side’s duration tolerance to highlight the dearth of natural demand for long-term tax-free bonds.

Today we’ll look at banks, which were once the primary buyer of municipal bonds.

Click for the 500 Largest ­Municipal Portfolios at U.S. Banks

The nation’s 6,500 commercial banks have more than $12 trillion in assets, according to the Federal Deposit Insurance Corp., making them a massive force in credit markets.

Unfortunately for the long-term tax-exempt sector, their capital structures mostly keep them anchored toward the shorter end of the tax-exempt yield curve.

Like most institutional investors, banks seek to match the duration of their assets with the duration of their liabilities. If a bank raises cash it knows it will have to pay back in five years, it seeks to invest it in an asset that also matures in five years. The goal is to earn a spread on the investment until they have to pay it back.

The matching of assets’ and liabilities’ duration is intended to immunize the balance sheet against a swing in interest rates. Ideally, an increase in interest rates would exert the same influence on both the banks’ liabilities and its investments.

Banks’ disclosure of the duration of their liabilities is mostly non-existent. We were only able to find three banks that quantified the duration of their securities portfolios in their latest annual financial statements.

All three of these reported durations of less than 4, even shorter than the average duration in property-casualty insurers’ fixed-income portfolios. The longest duration tolerance of the three was BB&T, whose securities portfolio duration is 3.97 years. PNC was the lowest at 3.1, with SunTrust not far off at 3.3.

A quick glance at the structure of banks’ liabilities explains why banks’ tolerance for duration risk is low. According to the FDIC, almost 80% of commercial banks’ $10.7 trillion of liabilities come in the form of deposits.

Most deposits can be redeemed momentarily, and the majority of deposits that have specified terms mature in a year or less.

Much of the remainder of bank liabilities is generally short-term in nature too. About 5 cents of every $1 of bank liabilities come from short-term financing such as repurchase agreements or federal funds borrowings, which in bank parlance constitute “overnight” funding.

So, similar to property-casualty insurers, banks’ need to match their securities portfolios’ duration with the duration of their liabilities gives them a preference for short- or intermediate-term debt.

With $246.1 billion of municipal securities, banks hold just 1.7% of their assets in state and local government debt. They own an 8.4% share of the $2.9 trillion municipal debt market.

Banks were nonetheless buyers of municipal bonds in a big way last year, thanks to the stimulus legislation.

The legislation lifted to $30 million the ceiling on how much an issuer can borrow in a year and still be considered “bank-qualified,” meaning banks can deduct the carrying costs of municipal bonds from taxable income. The tax incentive induced banks to expand their holdings by 13.7% based on a cost basis, according to Highline Financial.


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