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The Chase for Spring Paper Is On

MAY 25, 2012 7:47pm ET
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Spring is in the air — and for muni investors that means the hunt is on to replace paper that will mature in June and July when more than $70 billion in coupon payments and proceeds from called and maturing bonds hits their accounts.

Known as the two largest months for reinvestment, this year's spring rollover season will be no different than previous years in terms of the heavy demand that will be chasing new paper, two municipal experts said.

"It will be another large reinvestment season," said Guy Davidson, director of muni investments at Alliance Bernstein in New York City.

An estimated $49 billion of redemptions are slated for June 1, with another $35.48 billion on July 1, according to Interactive Data as of May 8.

Redemption data provided by the Bedford, Mass.-based research firm includes proceeds from bonds that have been current and advance refunded, as well as maturing bonds and notes.

Despite low absolute yields and supply challenges, experts say investors flush with redemption proceeds will reinvest a generous amount of that money in the municipal market come June and July 1.

Bill Walsh, president of Hennion & Walsh in Parsippany, N.J., said mom and pop investors should be ready, willing and able to spend their redemption proceeds in the tax-exempt market — especially since they have had some time to adjust to the current yield levels.

On Friday, the generic, triple-A general obligation bond in 30 years yielded 3.14%, according to Municipal Market Data. The same bond was yielding 3.39% back on March 30.

"On the retail side, individuals are being a little selective," Walsh explained. "We are down at a pretty historically low threshold, that's why individuals are being choosy."

For instance, Walsh has observed many investors shopping in both the primary and secondary markets with a preference for investment-grade bonds, both GOs and essential-purpose revenue bonds, which offer value and yield in the 20- to 25-year maturity range.

"Though we might have seen a little less actual buying recently, we haven't seen any less interest," he said. "I think retail is looking and they are going to be a little choosy, but I think they are going to be buying."

Davidson of Alliance agreed.

"I think that amount of cash is going to get plowed back into the muni market because people are looking for income and stability," he said.

The willingness to invest in municipals has been evidenced by recent risk-averse behavior. Many investors, nervous about developments in Europe, are exiting the equity market and seeking refuge in fixed-income investments.

Many are escaping the sub-1% yields on tax-exempt money market funds by heading toward tax-exempt mutual bond funds — particularly high-yield funds, Davidson said.

In the first five months of the year, he noted, investors have poured some $20 billion into municipal bond mutual funds. As of May 17, high-yield funds in particular had seen inflows for 22 of the previous 23 weeks, according to Lipper FMI.

However, as reinvestment season arrives, finding fresh bonds with the right characteristics could present a challenge given the supply obstacles in the current market, sources said.

The recent low interest rates will make it difficult for investors to replace their higher-yielding bonds slated for redemption, as well as the lack of net new supply in the face of a glut of refunding issuance.

Although volume recently increased 76.3% year to date from the same period a year ago, current refundings account for a majority of that surge, Davidson noted. A current refunding takes place when new bonds are sold and the proceeds are used to retire callable bonds that have higher interest rates.

"As many bonds are being called as are being issued," he said. "So, while new issuance has picked up, the net new supply has been fairly flat, which is why munis have done so well in here."

Davidson agreed that as reinvestment season approaches, investors could be hard-pressed to satisfy their need for income and safety in a market where rates are low and refunding are up, but said they are willing to make concessions.

"Supply is going to be hard," he said, adding that some investors are opting to sacrifice some credit quality to gain more yield, rather than extending on the curve.

"There is a pretty strong bid for single-A and triple-B bonds," he explained. "You can pick up a good amount of yield going down in the credit spectrum."

Davidson's firm manages $31 billion of municipal assets, consisting of high net-worth individual portfolios, separately managed accounts, and mutual funds.

Overall the strong demand and steady supply caused municipals to rally over the last month, and the reinvestment demand should help maintain the market's strength going forward.

"Retail investors realize where rates are now," Walsh said. "You have seen a fairly big adjustment in yields over the last month or two, so it takes retail a second or two of sticker shock to realize that this is the going yield."

But, when compared to other alternatives like corporates, agencies or Treasuries, he noted, investors ultimately realize that municipals are still relatively cheap.

"With taxable alternative yields low, effective tax-free yields are still attractive to the retail investor," Walsh said.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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