An expected swell in the volume of current refundings in the fourth quarter may be too little to cure the imbalance that's left municipal bond investors starved for supply for most of the year .
Though many borrowers have already refinanced at lower rates, municipal analysts say there is potential for municipalities to issue - and investors to absorb - increased capacity as 2014 comes to a close. While analysts could not put an exact figure on the forecast for current refunding volume, visible supply for the next 30 days was reported at $4.01 billion as of Wednesday, according to Bond Buyer data.
Any infusion of new supply would find eager buyers, analysts said, given the robust demand evidenced by flows into municipal bond mutual funds amid the supply shortage.
"Municipal bond funds have experienced net inflows 27 out of 34 weeks this year, after ending 2013 with 31 consecutive weeks of outflows," said Dorian Jamison, municipal analyst at Wells Fargo Advisors, citing Lipper FMI figures.
Year to date, long-term net new supply in the municipal market has fallen more than 15% and refunding volume in July is down over 20%. Current refundings refinance currently callable bonds generally issued more than 10 years ago.
Issuance has not been able to keep pace with investor demand so far in 2014 and the market "could certainly handle more supply," said Sean Carney, municipal strategist at BlackRock Inc.
Long-term refunding volume dropped by 23% year to date to $60.35 billion, from $78.42 billion over the same period last year, according to data provided by Thomson Reuters. New, long-term volume declined by 15.3% as of July 31 to $177.16 billion from $209.18 billion over the same period in 2013, the data showed.
In July alone, overall long-term volume dropped 20.4% to $24.01 billion.
"There is definitely a strong appetite among investors for municipal bonds, especially from high quality issuers," agreed Tom Kozlik, director and municipal credit analyst at Janney Montgomery Scott.
Sources said the recent low supply would help support municipal prices this week and next, ahead of Labor Day, but they are planning for the potential kick in refunding supply from issuers who have unmet refinancing needs.
"There is likely to be a steady supply of refunding activity, as long as rates cooperate," Kozlik said.
Chris Mier, managing director of the analytical services division at Loop Capital Markets, said it stands to reason there could still be a hefty volume of current refunding-eligible paper that would augment the seasonal increase typically seen in the last four months of the year.
"In 2006, 2009, 2010, and 2011 volume in the last four months of the year spiked considerably above the simple average of 33% that might be expected over the course of the remaining one-third of the year," he said.
Mier said the dramatic drop in interest rates from the beginning of the year "will no doubt produce more activity" in terms of issuance in general, including refunding volume.
The generic, triple-A general obligation scale, which started the year at 4.20% on Jan. 2, yielded 3.10% on Tuesday.
In the event that the added supply sends interest rates higher in the fourth quarter, Mier said it could be both worrisome and beneficial for the market, as some investors might be wary of buying into a sell-off, while others might see advantages.
"I think investors are more likely to view an increase in interest rates, particularly if it is partially induced by more supply, with caution rather than with a desire to aggressively purchase bonds at today's lower interest rates," he said. On the other hand, "investors may be glad to see a wider variety of bonds coming to market, however, and may view increased supply as an opportunity to adjust their portfolios."
Given the net-negative nature of issuance in recent years, spikes in supply have been viewed as an opportunity, Carney of BlackRock said.
"Greater supply creates greater price transparency," he said/. "Given dips in performance have been shallow and short lived, it would not be surprising to see any increase in supply as a buying opportunity ahead of year-end.,"
Additional refunding supply is likely to command keen attention from investors for its favorable characteristics.
"Refunding issuance is absorbed by the market rather easily as it creates its own demand -- often from those already comfortable with the credit -- whereas new money issuance needs a natural buyer tends to be longer in duration so it is often marketed to a more limited audience," Carney said.
While Anthony Valeri, investment strategist at LPL Financial, agreed that volume usually increases in late September and early October, he doesn't expect any great impact from the modest growth of current refundings.
"Refunding volumes have already increased, and while they're likely to remain higher compared to last year, I don't see it surging enough to upset the apple cart of low supply," he said. "Much of the refinancing due to lower rates has already occurred and it's difficult to envision a dramatic surge."
Others, like Mier, however, believe market conditions could be ripe for an uptick in refunding volume judging by past years.
In both 2004 and 2003 - when current refunding candidates were originally issued -- interest rates were higher, while volume was heavier compared to 2014's expectations, Mier pointed out.
"Today's interest rates are at, or below, where they were in 2004 and 2003, which does suggest that there may still be some bonds that can be current refunded, providing savings to the issuer," Mier said.
Valeri contended, however, that the effects will be muted. "Even with revenue gains, state and local budgets remain very tight and the capacity to add new debt remains limited," he said. "The amount of new issuance scheduled to come to market over the fourth quarter will increase, but remain low compared to prior years."
He estimated there will be $60 billion of maturing debt in the final four months of the year, which is less than what was reported in July and August and implies less reinvestment demand.
"Coupled with higher issuance overall, not just refunding related, less reinvestment means a slightly worse supply-demand balance heading into Q4," Valeri said.
But, timing is everything, Carney of BlackRock said, when it comes to the significance of the fourth quarter..
"We know that the Fed will conclude unconventional monetary policy in October and market participants will shift their focus to the date and trajectory of the first rate hike," Carney said. "Municipal issuance in October tends to be 30% greater than the prior month, hence performance is not particularly strong and volatility has the ability to increase during this period."
Additionally, Valeri said given the strength of year to date performance, he believes the Treasury market, overall valuations, and the timing of the Federal Reserve Board's stimulus exit will have a "greater impact" on the municipal bond market than a potential pickup in refunding volumes.
