Sell Side

Demand for Notes Should Climb This Season as Supply Steadies

As this year’s note season ramps up, market participants expect strong demand and issuance levels consistent with last year’s seasonal total of almost $39 billion.

Low borrowing costs will continue to entice municipalities to issue notes during the June-to-August period, when they typically need to raise money between the time when normal expenses come due and when all of their anticipated tax revenue arrives.

That will be offset by an improvement in state and local government revenue collection, which has reduced the need to go to the public markets to cover short-term funding gaps.

Demand should remain high this season because low interest rates persist and many investors have their money parked within three years. What’s more, investors and traders add, the need for notes remains for short-term funds that must replace expiring notes or reinvest.

“There’s still a tremendous demand for notes,” said Ron Schwartz, a portfolio manager of the RidgeWorth Investment Grade Tax Exempt Bond Fund. “In the short-term market, three years and in, there’s still a lot of demand there, because there’s a lot of cash still there.”

Many muni investors are conservative and concerned primarily with capital preservation, according to Schwartz. Accordingly, they’re interested in particularly short-term paper.

Because yields remain near historic lows, issuers will look for the opportunity to take advantage of relatively cheap financing, said Pamela Tynan, principal and head of short-term municipal fixed income at the Vanguard Group

Notes are 13-month paper that municipalities issue and are considered money-market eligible by Securities and Exchange Commission Rule 2a-7. Money-market funds, which have to buy securities that are 13 months or shorter, are typically big buyers of notes.

“Tax collections are sporadic [depending on] the city,” said William Henderson, portfolio manager and head of BlackRock’s municipal cash management team. “But their bills are flat — salaries, utilities, police forces, schools. So, if they waited until they received all of the money from taxpayers, they would have to pay their vendors sporadically as well.”

Notes are issued to bridge that income gap; they’re then repaid with tax receipts.

There are limits, though, on how much in notes state and local governments can issue, according to a trader in the short-term market in New York. When municipalities issue a note of the tax revenue-anticipation or revenue-anticipation variety, they can only issue as much as the largest shortfall that they had during the year.

“So, even though rates may be really low, they can’t issue a ton more than what’s permitted,” the trader said.

Almost $39 billion reached the market during the June-to-August span of note season in 2012, according to Thomson Reuters numbers. So far, note issuance in 2013 is up roughly 6% through April.

Analysts at Moody’s Investors Service don’t anticipate an increase in note issuance this year. Budgets are getting better on the state level, and states’ liquidity has improved, said Nick Samuels, a senior credit officer at Moody’s

Overall, the revenue trend for states is up, Samuels said. There have been 12 consecutive quarters of growth in state tax revenues, according to the latest state revenue report assembled by the Nelson A. Rockefeller Institute of Government at SUNY, Albany.

“It’s a positive trend for states’ liquidity overall,” Samuels said.

Eric Hoffmann, a manager who heads up local ratings in California for Moody’s, said that budgets appear to have stayed in balance for fiscal 2013, which ends on June 30. If anything, he added, slight revenue surprises, compared to the budget, are likely. Sales and property taxes for local governments in California are doing OK, he said.

“I expect the number of borrowers to be the same,” he said. “I suspect that they may borrow less than they did last year.”

The New York trader in the short-term market expects good demand from the money market funds again this year. And given the unlikeliness of rates rising, he added, investors should be more willing to extend a year on notes.

BlackRock’s Henderson and Vanguard’s Tynan agreed. As all the other notes have started to mature, funds start to develop a pent-up demand as they build up liquidity.

“Many of us who have replacement or reinvestment needs, those needs remain,” she said.

Notes should also perform favorably when compared to variable-rate demand notes because the yield curve still has some slope in it, albeit very slight, Henderson said. Thus, he added, muni money-market funds will look to notes to extend their maturities and pick up some yield.

“There should be strong demand for this, because there’s been a continued collapse of VRDNs in the market, as it becomes tougher to get banks to offer letters of credit and liquidity providers,” he said.

“So, that has created a pent-up demand for notes as we come into note season; people are trying to replace what matured throughout the year.”




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