The historically-low yield climate in the municipal market is putting more focus on cost-savings than ever before among the retail crowd, municipal strategists said.
Mom and pop investors have shown increasing demand in recent months for lower-coupon, lower-priced bonds – specifically 4% coupons – as an alternative to the previous 5% market standard, they said.
"As rates have come down dramatically over the years, 5% coupons have become very expensive -- especially in the 10-year part of the curve," Peter Block, managing director of credit strategy at Ramirez & Co. said on Friday.
"It was therefore natural for retail investors, who are averse to paying premiums and are typically buy-and-hold investors, to gravitate towards lower priced, lower coupon bonds to achieve income needs," Block added.
Lately that has meant coupons of 4% -- and in some cases even lower – are becoming more palatable to retail buyers because they decrease individual investors' dollar price, the experts said.
"The market has had to make an adjustment to the new couponing, and I think it's long overdue because rates have been at such a low level for such a long period of time," Jim Colby, senior municipal strategist at Van Eck Global, said in an interview on Thursday.
He said the trend toward 4% coupons was building gradually before intensifying in the last quarter.
The trend is most noticeable in the new-issue market, municipal participants said, where 4% coupons are being structured to meet retail's preference and getting strong demand as a result.
"There has been a demand from retail and other financial advisory firms for new issues to come to the market place with a structure that doesn't show a premium price as a 5% coupon structure," Colby said.
"It's fairly evident out there recently that new big issues are coming to the marketplace in the investment-grade world with 4% coupons," he added.
"Issuers that target retail participation and have coupon flexibility, therefore, may structure a portion of a new issue with lower coupons to bring down dollar prices and attract retail orders," Block said.
"It's marrying up the desires of the buyers of the bonds and the desires and needs of the issuers," Colby continued. Issuers, he said, "can length out the amortization schedule and realize a cost savings."
He cited the $550 million Illinois general obligation deal that priced on June 16, in which 4% coupons had a strong retail following, and the deal "got done pretty handsomely – despite all the credit problems they are having."
The bonds are the lowest rated state in the country – with Baa2 from Moody's Investors Service and BBB-plus from S&P Global Ratings and Fitch Ratings. All three raters have negative outlooks on the credit as the state continues to face fiscal debacles, including a prolonged budget impasse and pension funding crisis.
At the official pricing, the issue was priced to yield from 1.32% with a 5% coupon in 2017 to 4.05% with a 4% coupon in 2037; a 2041 term bond was priced as 4s to yield approximately 4.11% -- which was 172 basis points above the comparable security on MMD's 4% scale at the time of pricing.
Colby owns the 4% coupons of 2034 from the secondary market, which were originally priced at $100.486 with a 3.94% yield, according to Interactive Data Corp.
A $10 million block of the bonds traded on Friday at a price of $101.09 with a yield to maturity of 3.91%, according to MMD. The bonds traded as high as $103.89 on July 7 with a 3.53% yield, according to MMD trade history.
"They likely would not have realized that big of a price improvement if the bonds were at 5% coupons," Colby said. "The demand for the bonds was strong enough to provide people with the opportunity to earn price return."
Rick Calhoun, a first vice president of sales and trading at Little Rock-based investment banker Crew & Associates, said that while steady demand for lower coupons with a modest dollar price and less premium has long been a popular retail strategy, the trend is more prevalent than ever considering the low rate environment.
Some retail investors have even decreased their acceptable coupon threshold to as low as 2%, judging by the strong demand for new issues, he and Colby noted.
"Since rates have plummeted, 3% -- and even 2% -- coupons are becoming more common to satisfy retail demand, especially in the 10 to 12-year maturity range," Calhoun said.
"Little by little we have seen deals come to the marketplace in 2040 where one tranche has a 4% coupon and a 2% coupon," Colby said.
It's a way to draw in the investors who think the market still has price performance built into it, he added.
"I don't think we are moving to seeing 2% being the standard, but we are starting to get some momentum toward 4% in the marketplace," Colby continued.
"If they are buying bonds with 2% coupons – and paying 98 cents on the dollar at discount – the price might rise to $101 and it will do so quicker in terms of providing price performance than a bond that comes to market at 4% or 5%," Colby said.
The Illinois GO deal can be viewed as a tracking benchmark for the start of the sub-5% coupon trend and the market's general acceptance of 4% coupons.
"The marketplace didn't penalize the state of Illinois for having a 4% coupon as opposed to a 5% coupon, which has been – until the last few years – the standard," Colby said.
Overall, experts believe the recent behavior could evolve into a longer-term market trend if the historically low-yield climate continues as analysts expect.
Colby suggested bankers and public finance officials could continue to engineer new deals with different couponing structures to meet the different expectations and needs of the investing audience.
A 4% coupon structure is "more palatable" in terms of issuers establishing a lower net interest cost – and therefore feeding retail's hearty appetite, he said.
"We have been in this low rate environment for a long time and that has given rise to the notion that – until the foreseeable future – a 4% coupon is not going to be harmful to the buyers or the issuers," Colby said.
Whether 4% coupons will become the market standard is hard to say, according to Colby, though he noted that 46 consecutive weeks of inflows into municipal bond mutual funds indicates that demand for tax-exempt product continues to be strong.
"That in and of itself emboldens bankers and underwriters to be more accommodating to the issuers," Colby said.
