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Low Yields and a Refunding Flood Confound Investors

JUN 26, 2012 9:04pm ET
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Refundings, which comprise the bulk of this year’s boost in supply, have been shaking up the market for municipal bond investors.

Analysts Differ on Outlooks for New Money Bond Volume

Demand for muni paper remains robust even as relatively little new money borrowing is taking place, reducing supply and pushing yields lower. This comes at a time when new bonds offer much lower rates than the debt many investors currently own.

The flood of refunding bonds has also been driving up demand by taking higher-coupon bonds out of the market. Consequently, more investors and fund managers have been compelled to accept new coupons at extremely low rates, said Rob Williams, director of income planning in the Schwab Center for Financial Research at Charles Schwab.

“Any of that refunding activity is coming at much lower yields than what many investors were holding previously,” Williams said. “To the extent that debt was callable, that debt was pricing in anticipation of that. But certainly, either way, that’s leading investors and fund managers to go out and look for coupons in a pretty unattractive rate climate.”

In addition, other long-term investors have been saddled with longer-duration bond portfolios in a shorter-duration bond environment, according to Michael Brooks, a senior portfolio manager at AllianceBernstein.

They are struggling with negative convexity where, after interest rates fall, a bond’s duration shortens because it is now measured to its call date rather than its maturity date, he said.

“To the extent that some investors bought long callable bonds years ago at higher yields and hoped that falling rates would add big returns due to their long duration, [they] might have been surprised when yields fell and the duration dropped sharply,” Brooks said. “These investors got a lot less return because the duration contracted as yields fell.”

The muni marketplace appears on track to issue $375 billion this year, according to Joe Deane, executive vice president and head of munis at PIMCO. Refundings represent more than 60% of the volume to date, according to PIMCO numbers.

The last time refundings made up this much of long-term volume was 1993, when they were 67% of the $290.26 billion issued, according to Thomson Reuters. By comparison, refundings represented 49% of long-term volume issued last year, and averaged 35% each year from 1994 through 2010.

If rates hover at these levels, as is likely, this activity should continue through the end of next year, industry pros said.

Through May, year-to-date refunding issuance has increased around 120% from 2011 levels, Citi analyst George Friedlander wrote in a research report. That means bond calls will be significant through 2012 and into 2013 as more bonds reach their initial call date.

With hefty numbers of maturing bonds and massive amounts of bond calls from current and advance refundings, Citi estimated that the net supply of bonds will be negative $39 billion through June, and negative $55 billion through July.

Total maturities and calls for the period of May through July will be $142 billion, Citi estimated.

“We think this is the biggest three- months bond-call maturity period in the history of the market … by a lot,” Friedlander told The Bond Buyer.

Those refundings that have been used to retire refunded bonds within 12 months of the issuance of the refunding bonds began to jump suddenly around September 2011, as muni yields fell significantly, Friedlander wrote.

And the calls resulting from those refundings are still in the process of cresting.

“The bottom line is that both institutional and retail investors hold massive amounts of higher-coupon paper that is imminently reaching the end of its life as a result of maturities and bond calls,” he wrote. “This pattern, in turn, is generating pent-up demand for new munis, despite yields that appear unattractive by historical standards.”

A current refunding, the most common type these days, takes one bond out of the market and replaces it with another bond. In doing so, it does not increase the size of the debt outstanding in the muni marketplace by any appreciable amount, and thus, does not increase overall supply. “So, there’s no upward pressure on yields,” Brooks said.

The problem is that a very large portion of individual investors has been highly resistant to lengthening out their portfolio along the yield curve for years now, and has been holding on to their high-coupon, short-call paper for dear life, Friedlander said. And now their portfolios are getting hit with near-term calls from current refundings.

As a result, investors are feeling squeezed. “The direct retail investor in municipal bonds is struggling,” Friedlander said. “And he hasn’t resolved the issues of lower rates and the fact that they’re getting so much cash back so quickly.”

At AllianceBernstein, muni fund managers are looking to maximize total return after taxes. So they don’t want to buy really long bonds and lock in a yield in the lowest rate environment the market has seen in 60 years, Brooks said.

“Locking in low yield in a low-yield environment for a long period of time does not make sense,” he said.

Over the long term, these trends will hold yields tightly in range and render the muni market significantly less volatile in both directions than the Treasury market. If rates fall from current levels, more rate shock and refundings will follow. If rates rise — even by, for example, 40 basis points — there will many relief trades, as investors will be desperate to put their money to work.

All of this has also prompted a push down the credit scale among investors and funds that are looking for higher yield, Williams said. And that has led to tighter credit spreads.

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