Buy Side

Crossover Buyers Skirt Munis Despite Ratios to Treasuries

Despite Treasury outperformance and cheap ratios to municipal bonds, crossover buyers are keeping their distance from the tax-exempt market.

Muni ratios to Treasuries are at cheap enough levels that normally would attract non-traditional, or crossover, buyers into the market.

But compared to corporate bonds, crossover buyers’ typical investments, munis just aren’t attractive enough, industry analysts said.

“We haven’t seen as much as you would think you would see, given where ratios are,” said Michael Zezas, vice president of municipal bond research for Morgan Stanley. “There’s enough spread in other credit markets that ratios would need to be meaningfully higher in order for munis — on a pure spread-to-U.S.-Treasuries-basis — to match the spreads of similar credit-quality bonds in the corporate market.”

In other words, the numbers don’t work for crossover buyers. A triple-A muni bond ratio to Treasuries would need to rise significantly to look attractive to them.

Munis have been underperforming Treasuries recently, but so have corporates, Citi analyst George Friedlander wrote in a research report.

That has changed spreads and ratios to Treasuries, respectively, for both bond markets, but not much against one another.

By the end of last week, “in the 30-year range, for example, double-A munis are around 3.40%, only 78% as much as double-A corporates, which are at 4.37%, or so,” Friedlander wrote.

As of Monday, if a double-A muni bond is to match the kind of spread that you can get from a non-financial double-A bond in the corporate bond market, a spread to Treasuries of 98 basis points is required.

That would translate into a Municipal Market Data yield that is 37 basis points higher — at a ratio of 142% — in order to achieve that spread, Zezas said.

“We’re quite a ways away from that,” he said.

And ratios don’t need to increase as much the farther down the credit scale one moves.

For a single-A bond to be equivalent to an A-rated corporate bond, spreads to Treasuries would need to reprice only 22 basis points higher, based on the current single-A spread to MMD, Zezas said. And that would translate to an adjusted MMD ratio of 133%.

As muni ratios to Treasuries climb into cheaper territory, they can also rise against corporate bonds, making tax-exempts attractive to crossover buyers.

And by buying enough munis, crossover buyers can act as a stopgap in the market, according to Ashton Goodfield, a managing director and portfolio manager at Deutsche Investment Management Americas.

Crossover investors “can become strong enough marginal buyers that they can provide some stability to a cheapening muni market,” she said. “It prevents them from getting cheaper than they otherwise would.”

Crossover buyers buy when there is selling pressure in the market, as long as they need bonds and view ratios to corporates as attractive. They sell when the market needs sellers with the same needs and factors in place.

Currently, triple-A muni ratios to Treasuries lie in cheap territory by any measure, according to MMD numbers. The benchmark 10-year stood at 115% by Tuesday’s close. It has risen almost 20 percentage points since March 14.

The two-year and 30-year settled at 110% and 116%, respectively. They have risen 33 and 16 percentage points, respectively, since March 14.

The presence of crossover buyers in the primary and secondary markets has grown over the past couple of years as these investors have become increasingly more comfortable buying tax-exempt paper, Goodfield said.

More buyers were introduced to the muni market from the Build America Bond program starting in 2009, as well as from recent experiences with other taxable munis.

They have become aware that credits are solid and that default rates are much lower than corporates, Goodfield added. “Munis have attractive return-versus-volatility characteristics in the market,” she said.

Crossover buyers, defined loosely, are buyers that typically wouldn’t transact in tax-exempt muni bonds for a couple of reasons, according to Zezas.

They either can’t take advantage of the tax benefits of owning munis, or it’s explicitly their mandate to create taxable income.

Hedge funds are going to buy muni bonds when it’s effectively a cheaper way to get relatively high-quality credit, versus corporate bonds. They will use it as a replacement for corporates on a taxable basis.

But the investors aren’t just hedge funds, Zezas added. It could be anyone who’s running an investment-grade corporate bond portfolio who might buy munis on a tactical basis.

An example might be an insurance company that finds that credit is cheaper in the muni market, and so it will cross over into it.

“It’s really ill-defined,” he said. “It’s really about where the buyers themselves don’t specifically have the mandate to generate tax-exempt income.”

Numbers on crossover buyer participation in the market are difficult to assemble, Zezas said.

The Municipal Securities Rulemaking Board will break down trades by dealer-to-dealer and dealer-to-customer. Analysts can break down trades by size within that.

But it is difficult to distinguish a traditional muni buyer from the nontraditional variety.

The Federal Reserve’s flow of funds, which is released on a quarterly basis, isn’t timely enough to catch shifts in the market.


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