Tender-option bond programs last year lost a lot of money on a controversial premise: that long-term municipal bond yields are fundamentally and inefficiently too high.
The roaring success of Build America Bonds over the past two weeks have hammered down the long end of the yield curve in the past month and raised an interesting possibility. Maybe the TOB programs were right.
Rampant buying of long-term munis has knocked 63 basis points off the yield to par call and 29 basis points off the yield to maturity on The Bond Buyer index since March 18.
That has flattened the yield curve.
The spread of the triple-A muni at 30 years over the triple-A muni at one year narrowed by 40 basis points in the 25 trading sessions ended Wednesday, according to Municipal Market Data.
Market participants say BABs have brought down yields on the long end and flattened the yield curve for two reasons.
First, by encouraging issuers to sell debt in the taxable market, they transfer significant issuance from the tax-exempt market. That leads to less supply. Some forecasts call for $150 billion of BAB issuance over two years.
"It's not going to eliminate all the supply in the longer end, but it is going to reduce it," said Ron Schwartz, who manages muni funds at StableRiver Capital Management. "There's a little bit of a feeling that there's not going to be an incredible supply overhang in the municipal market in that long end."
Second, the clear demand for munis outside the tax-exempt market helps spotlight the attractiveness of munis. At tax-free rates, munis have far lower default rates than corporate bonds.
"It points out how cheap munis are at the long end of the market," said Jed McCarthy, managing director at 1861 Capital Management.
The puzzling cheapness of long-term munis is not a new concept. An entire industry sprouted to exploit the perception that long-term muni yields were simply too high.
TOB programs were designed to arbitrage what they perceived as an inefficiency. The yield curve for munis was steeper than the curve for taxable fixed income like corporate bonds and Treasuries.
This was empirically true. Throughout the 1990s, the 30-year Treasury traded an average of 121 basis points higher than the two-year Treasury, according to MMD. By comparison, the yield on triple-A munis at 30 years on the MMD curve was 171.8 basis points higher than the triple-A two-year.
From 2000 through 2005, the yield curve for triple-A munis based on the 30-year over the two-year was about 35 basis points steeper than the London Interbank Offered Rate swap curve.
McCarthy offered two explanations for why this discrepancy exists.
First, tax-exempt yields are influenced by changes in the tax rate. Because one cannot predict what tax rates will be in 30 years, the curve steepens to reflect the uncertainty.
Also, issuers like to sell long-term debt while retail investors like to buy short-term debt. That tilts the supply-demand balance, resulting in more long-term supply than demand, he said.
TOB programs taking positions arbitraging long-term muni yields against short-term yields entailed buying munis at the long end.
This helped flatten the curve, with the 30-year triple-A just 39 basis points higher than the one-year in February 2007. Less than four years earlier, the spread was as high as 412 basis points.
The flatter curve did not last. More than 35 muni arbitrage funds were forced to liquidate during the financial crisis last year. By last month, the spread of the 30-year over the one-year was back up to 435 basis points.
Market participants say it is too early to determine whether BABs can do what TOB programs were able to do only temporarily.
The biggest obstacle is legal. The legislation creating BABs expires in two years. It is possible the federal government will extend the program before it sunsets. Predicting that is not possible.
"That inefficiency would only go away in the long term if BABs are around in the long term," said Guy LeBas, director of fixed-income strategy at Janney Montgomery Scott.
That said, LeBas believes the enthusiastic reception for Build America Bonds "does have implications for a flatter yield curve in the long run."
"You've got real money chasing that same inefficiency," he said.
McCarthy, whose fund employed the TOB arbitrage strategy, does not believe BABs will eliminate the inefficiency of excessive long-term muni yields.
Issuers will only sell BABs if it is cheaper than selling tax-exempt paper. Once yields at the long end of the tax-exempt curve become slim enough, selling tax-exempt paper will become cheaper than selling BABs, he said.
McCarthy pointed out the curve is still steep, even if it has flattened a bit. Triple-A 30-years yielded 400 basis points more than the one-year, as of the close of the market Friday, according to MMD. The average spread of the 30-year over the one-year since 1990 is about 225 basis points.
"It could lead to some tightening there, potentially," said Jeffery Timlin, a portfolio manager at Sage Advisory Services. "Like every other market, we're in new times. We're trying to feel our way through. The dynamic right now is a lot more complex than it ever has been."