Investors six weeks ago were practically unanimous in believing municipal bonds were cheap. Now some are not so sure.
Munis staged a robust, month-long rally from mid-December through mid-January.
The market last week digested the biggest supply of new bonds - $7.7 billion, according to Bloomberg - since the Lehman Brothers Holdings Inc. bankruptcy.
Muni mutual funds earlier this month finally attracted cash flow from investors after nearly four consecutive months of outflows, according to AMG Data Services.
The surge in muni prices followed a drumbeat of optimistic commentary from investors and analysts.
Market prognosticators from Pacific Investment Management Co.'s Bill Gross to Barron's Magazine have touted municipal bonds as stable sources of return during hard times. It was next to impossible to find bears in the muni market forest.
For much of December, virtually any measure showed municipals were undervalued. Most glaring, the triple-A rated, 30-year muni yielded a once-unthinkable 200% of Treasury bonds with the same maturity, according to Municipal Market Data.
Most people believed this could not last. They were right.
The yield on the a triple-A rated 10-year muni squeezed from a high of 4.86% on Oct. 15 to a low of 2.82% last week. That is the lowest yield on record in nearly three decades of data available at MMD.
While many metrics still demonstrate compelling value in municipals, other metrics show there is now at least room for doubt, some market participants say.
The 10-year, triple-A muni now yields 119.1% of a 10-year Treasury. While still far above the historical norm, that is far below the peak of 186% reached Dec. 18.
"The marketing of munis as 'cheap' has become substantially less credible," Matt Fabian, managing director at Municipal Market Advisors, wrote in a report this week.
Fabian is skeptical municipals will hold at such high levels. He even referred to a "bubble" in prices for high-quality munis.
A number of factors could pop the bubble, Fabian reckons. Tax-exempt bonds have benefited from expectations of federal legislation lending support to the muni market. The extent of support might disappoint investors, he said.
Plus, with the economy more than a year into a recession, bonds could suffer from rating downgrades, Fabian said, either to a muni issuer or to a corporate counterparty.
"A shock is still likely to occur at some point," he said. "Participants should thus be looking for potential shocks that would prick the current bubble."
Moody's Investors Service agreed with Fabian about the risk of downgrades. In a report Wednesday, it warned of more downgrades to issuers as shrinking tax receipts crimp municipal budgets.
"The U.S. is facing the most severe recession in decades, drawing parallels to the Great Depression, and most, if not all, state governments are confronting large out-year budget gaps," Moody's said. "In 2009, issuers are expected to see further deterioration in credit quality as a result of the negative economic outlook."
George Friedlander, managing director and fixed-income strategist at Citi, attributes the run-up in muni prices to renewed interest from institutional buyers, unattractive interest rates on other types of short-term investments, and the expectation of help from a stimulus package from Congress.
Mostly, though, municipal prices were simply too low, he said.
Now that prices have rebounded, Friedlander expects muni prices to remain in a "tug of war."
"Much of the relativeness 'cheapness' of high-grade munis is gone," he said. "Whatever 'extra' value is left is now mostly in the 15- to 25-year maturity range, and in some cases, on new issues."
Friedlander said investors should consider lower-rated paper on a case-by-case basis.
A triple-A rated, 20-year muni trades at 157.4% of a 20-year Treasury. The yield compressed a full percentage point between Dec. 16 and Jan. 15. It is currently 4.69%.
Assessing the significance of the municipal-Treasury relationship is not easy because many people believe Treasuries themselves are in a bubble.
The yield on the 10-year Treasury last week compressed to 2.21%, down from more than 4% in October. After a sell-off this week, the 10-year Treasury yesterday yielded 2.58%.
John Derrick, director of research at U.S. Global Investors, thinks the ratio of muni and Treasury yields will continue to converge.
He predicts Treasury yields will climb and muni yields will decline until the two roughly match - perhaps at around 2.7% for the triple-A 10-year.
"A bubble in munis? I don't see that," said Derrick, who manages both municipal and Treasury funds. "I think the rally continues. ... I think there's some value."
The rally teetered last week. The yield on the 10-year, triple-A ticked up three basis points on Friday, six points Tuesday, four to six points Wednesday, and three points yesterday.
Phil Fang, a fixed-income portfolio manager at Invesco PowerShares, said when the market was in the doldrums last month many munis were priced at a discount to par, which attracted retail investors.
Following the rally, some of these discounts have shrunk or disappeared, which may have dampened demand, he said.
"That kind of put a pause on the market," he said.
Fang still sees value in municipal bonds. For an asset with a historically minimal default rate, Fang said yields on munis are still too high relative to Treasuries.