When will the muni market rally end?
That’s the question on everyone’s mind as continued appetite for tax-exempt paper drove muni-to-Treasury ratios to their lowest levels of the calendar year on Thursday, indicating that buyers continue to scramble for municipals despite low relative values.
“We were stronger despite a sell-off in Treasuries,” a trader in New York said. “We simply don’t have enough supply to meet demand. I’m seeing more purchases from insurance companies, funds, money-manager types, and trust buyers.”
Tax-exempt yields fell three to five basis points across the curve, as Thursday marked the 23rd consecutive session in which muni prices were stable or rising.
“The primary driver is there isn’t a tremendous amount of supply,” a trader in Florida said. “So blocks are cleaning up — guys don’t want to be left with empty shelves.”
The benchmark 10-year muni yield fell four basis points in the day and eight basis points over the week to 2.66%, its lowest since Nov. 12, 2010, according to Municipal Market Data. The 10-year yield has now dropped 58 basis points since April 11.
The two-year yield fell six basis points in the week to 0.48%, extending its one-month rally to 20 basis points. The 30-year yield fell six basis points in the week to 4.39%, down 44 basis points in the month to mark its lowest since Dec. 6.
Thursday’s rally was significant for its juxtaposition to the weakening Treasury market, where the 10-year yield backed up five basis points to 3.22%. The two-year yield finished a point higher at 0.56% and the 30-year yield rose four points to 4.34%.
The tax-exempt rally drove the 10-year muni-to-Treasury ratio to 82.35%, its lowest in exactly one year. The ratio was 91.6% on April 11.
The two-year ratio fell to 85.7%, its lowest since April 11, and the 30-year ratio came in at 100.9%, its lowest since Nov. 15.
Randy Smolik, in his daily commentary for MMD, noted that as the Treasury auctioned $16 billion of 30-year bonds in the afternoon, “muni bidders still seemed anxious to pay aggressive prices.” Once the auction was revealed as weak, however, “the bullish momentum of the session suddenly waned.”
He added: “Lack of buoyancy in Treasuries could make trading tricky from here on.”
John Dillon, chief muni strategist at Morgan Stanley Smith Barney, noted that market sentiment has been “very, very strong, even with this past week seeing one of the biggest supply weeks of the year.” Yet he’s not sure the market can keep going forward if Treasuries weaken in a significant way. “The levels we’re at now, I think, will give some people some pause before going further,” he said.
In Thursday’s new-issue market, Barclays Capital priced $236.7 million of revenue bonds for the Illinois Finance Authority on behalf of the Carle Foundation. The bonds were rated A-plus by Standard & Poor’s and AA-minus by Fitch Ratings. Yields ranged from 3.13% in 2016 to 6.18% in 2041.
The deal included $75 million of bonds enhanced by Assured Guaranty, offering 6.08% and maturing in 2041.
Wells Fargo brought $40 million of revenue bonds for the District of Columbia on behalf of Gallaudet University — the first borrowing ever for the school. The debt, rated A2 by Moody’s Investors Service and A-plus by Standard & Poor’s, offered yields from 1.85% in 2013 to 5.72% in 2041.
The consensus among traders a month ago was that a surge of tax-exempt supply was just around the corner and that when it hit, buyers would exit the market and yields would jump across the curve.
Instead, the opposite has happened: supply has continued to be light, new pockets of demand have been brought it, and yields have been slashed to their lowest levels since November.
An April 8 MMD survey found that 9% of traders were bullish over the coming one to two months, whereas 73% were bears. By last Friday, sentiment had completely reversed: 15% were bearish and the rest were bulls.
“The initial fear at the beginning of the year has been nothing but elusive,” said Rob Novembre, managing director at Arbor Research and Trading. “Everyone is rightfully concerned about it, but here we are, almost mid-way through the year, with no wave of supply.”
Novembre, whose firm trades in the secondary market, said the lack of primary issuance has made trading a little more challenging for some investors — buyers who typically look to the primary market for supply have had to now focus more on the secondary market if they want to get invested.
“Could the market be setting up for a sell-off?” Novembre asked. “Yes, it’s feasible. You do start to get uncomfortable in a market that just keeps going up and up and up. You have to feel that at some point it could come off.”
Dillon said the muni market has been playing catch-up after over-hyped fears in late 2010 initiated a sell-off.
“The sheer passage of time without any muni Armageddon is going to give people comfort, in conjunction with state and local governments making tough choices to balance their budgets,” Dillon said. “There is a lot more good news in the muni market than investors have been willing to embrace. I think they are playing catch-up now for the high anxiety they experienced for so many months.”
Alan Schankel, managing director at Janney Capital Markets, says that issuance has been so light this year that the outstanding volume of the total muni market at year-end could actually be less than at the beginning.
“The total amount of maturing muni debt in 2011 is expected to be in the $250 billion range, so with new-issue volume on a $200 billion pace, the year could end with fewer bonds outstanding year-over-year,” he wrote Thursday. “Even if the new supply pace accelerates, as we expect, there should be enough reinvestment demand to absorb supply.”
A major factor going forward is what impact the Federal Reserve could have as its second round of quantitative easing concludes June 30.
The monetary program has been focused on purchasing Treasuries in the five- to seven-year range, so analysts at Citi point out that buying pressure in those areas is likely to weaken, leading to lower prices and a flatter yield curve.
“Correspondingly, we expect AAA MMD flattening to remain the dominant theme, thus mirroring the flattening of the Treasury curve,” they wrote in a research note this week.
Citi’s preferred strategy continues to be purchasing longer-term tax-exempts while selling five-year munis, in the expectation that the yield curve will flatten out.
“In the environment of low rates, yield-hungry investors are increasingly looking at the long end of the curve for yield pickup, and the continue paucity of long-dated supply will serve to support long-date dated bonds,” they wrote.
The Bond Buyer’s 20-bond general obligation index of 20-year GO yields declined eight basis points this week, to 4.61%, a 24-week low. The 11-bond GO index of higher-grade 20-year GO yields dropped eight basis points this week, to 4.35%, also a 24-week low.
The Revenue Bond Index, which measures 30-year revenue bond yields, declined four basis points this week to 5.41%, a 19-week low. The Bond Buyer’s One-Year Note Index dropped three basis points this week to 0.43%, a 33-week low.
The average weekly yield to maturity of the Bond Buyer Municipal Bond Index, which is based on 40 long-term bond prices, declined six basis points to 5.46%, the lowest since Dec. 9, 2010.
