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Market Close: Munis Weaken a Little as Week's Largest Deal Arrives

AUG 22, 2011 5:01pm ET
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NEW YORK — The municipal market engine was slow to turn over Monday, despite the pricing of the largest deal of the week, which hit the wires a day ahead of schedule.

The market overall seems firm, though there was only middling activity in the day's session, said a trader in New York.

"It seems like there's still business going on," he said. "Phones weren't ringing off the hook, though. The game is still the high grades; that's where everyone's playing."

Tax-exempt yields were either mostly flat to slightly weaker on the day, with the back end of the curve a tad steeper, according to the Municipal Market Data scale.

Yields for maturities in 2019 slipped one basis point. Those beyond 2024 inched up one basis point. All others were unchanged.

MMD analyst Randy Smolik described the market's drivers in his daily report. "Large asset reallocation trades overnight set the stage for stock market bounce and treasury market drift," he wrote. "Short/intermediate munis shrugged off the modest range of treasury trading. But, in longer munis, after the market was pushed to respond to rallying Treasuries last Thursday, there was less buyer sponsorship as choppy Treasury markets led to more flexible in secondary offer-side roughly 15 years and longer."

Muni yields were mostly flat across the curve Monday. The 10-year muni yield held at 2.15%, the lowest closing level ever recorded by MMD.

The two-year muni yield stayed at 0.30%, its lowest yield in more than 40 years. The 30-year muni yield ticked up one basis point to 3.80%.

Treasury yields softened to start the week. The benchmark 10-year Treasury yield ended up two basis points higher to 2.09%.

The two-year yield ticked up one basis point to 0.21%, three basis points above its all-time low.

The 30-year yield climbed two basis points to 3.41%; last week it flattened the yield curve by plummeting 33 basis points.

Selling pressure in the secondary market will likely increase over the following week or two as dealers try to unload inventory that has started to get "heavy," the California trader said. Dealers have purchases from last week on their books that they cannot turn over, he added. And, as the inventory represents credits the market has seen, there's a call for new material.

"So, it's a push to get rid of this stuff, because they're not going to bring in anything new until they can sell the old," the trader said.

Some inventory the trader noticed includes large California deals, such as those issued by the Southern California Public Power Authority, the California Department of Water Resources, and the San Francisco Public Utility Commission.

"There's a lot of stuff," he said. "It's all concentrated in that longer than 10-year area, 15-year area plus or minus."

New issuance remains lackluster. Industry estimates predict municipal bond sales of $3.65 billion this week, versus a revised $4.72 billion last week.

In negotiated deals, JPMorgan priced for institutions $494.3 million of King County, Wash., sewer revenue and refunding bonds, a deal that had been expected Tuesday. The bonds are rated Aa2 by Moody's Investor Service and AA-plus by Standard & Poor's.

Yields range from 0.29% with coupons of 2.00% and 5.00% in a split maturity in 2013 to 4.27% with a 5.00% coupon in 2041. Debt maturing in 2012 was offered in a sealed bid.

At repricing, yields at the short end of the curve firmed three basis points. But they softened three basis points at the long end of the curve at repricing, as well.

"JPMorgan actually moved their King County, Wash., deal up, institutionally, to today; retail was Friday," a trader in California said. "That tells you the confidence they have in the market liquidity going forward. It caught guys a little off guard; we're used to the Tuesday-Thursday thing. Now guys are moving deals toward the beginning of the week."

Considering market conditions, munis are fairly valued, wrote Citi fixed income analyst George Friedlander in a recent report.

Munis lagged Treasuries significantly during the recent plunge in yields. Consequently, there's been a significant increase in muni yields as a percentage of Treasury yields.

"Yields on paper six years and shorter remain unacceptably low, in our view, and the benefit to be gained from moving out even modestly on the yield curve is impressive," Friedlander wrote. "Indeed, we believe that yields are still fairly attractive, all the way out to the 17-18-year range or so. However, we are not in a hurry to put cash to work."

Citi expects new issuance to rebound after Labor Day. Subsequently, yield levels and product availability should be better at that time.

Munis are still relatively thinly traded and lack price discovery. The market can attribute this to slight new issuance in recent weeks and the incredible market volatility of the prior two weeks, Friedlander wrote.

Also, there's value to be had in the intermediate part of the curve, JPMorgan fixed income strategist Peter DeGroot wrote in a recent report.

Using leverage conservatively in the intermediate sector of the curve yields more than does investing in 30-year high-grade bonds, he wrote. What's more, he added, levered intermediates boast "comparable duration risk, far greater roll down, and a more liquid exit strategy."

Also because of retail and managed investment interest, intermediate-term investments carry more liquidity than 30-year high-grade structures, DeGroot wrote. And, he added, levered investments bring less down-side exposure in an environment of rising rates as credits extend out along the curve.

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A recent phenomenon is the emergence of bonds with shorter call protection as funding alternatives for municipalities. However, the shorter call protection also dampens the potential upside for investors, which in turn reduces the price they are willing to pay.

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