The dearth of tax-exempt issuance and exodus of investors from volatile equity markets have translated into lower yields across the curve in the traditional municipal market, prompting some analysts to question whether long-bond buyers will continue to assume the duration risk for such minimal gains.
The yield spread between triple-A rated five-year bonds and one-year notes was 84 basis points Friday, according to Municipal Market Data. One year ago, the same spread was 138 basis points.
The flatter yield curve is partly explained by the influence of taxable Build America Bonds, which have constricted supply of tax-exempt debt by giving issuers a wider investor base for their offerings.
Tax-exempt issuance fell nearly a fifth in the first eight months of 2010, while total municipal debt volume rose 1.3% to $262.5 billion, according to Thomson Reuters.
The flatter yield curve could arguably dry up demand for longer-term debt, according to JPMorgan fixed-income analysts Chris Holmes and Alex Roever.
“With short-end yields stable, flight-to-quality episodes have been transmitted in longer maturities,” the analysts said in a research note. “A flatter curve might reduce incentive to abandon money markets for longer-term securities because the yield enhancement is not as attractive.”
As evidence they point to the lower volume of inflows into tax-exempt mutual funds relative to last year. The funds saw inflows of $27.6 billion in the first 35 weeks this year, according to Lipper FMI. The figure was $62.5 billion for the previous 35 weeks.
Lower inflows suggest muni investors are not moving from short-term to longer-term investments, even though short-end yields are almost absurdly low. Triple-A rated one-year notes yielded 0.26% Friday, compared with 0.40% one year ago, 1.58% two years ago, and 3.60% three years ago, according to MMD.
Tax-exempt investors wishing to maintain revenue levels have few options, but one is to step down the credit curve rather than move out on the slope, said John Dillon, chief municipal bond strategist at Morgan Stanley Smith Barney..
“Spread product, specifically A-rated, is one of the few remaining areas of value in tax-exempts,” Dillon said Friday in a research note. “We suggest continuing to use this strong market to liquidate weaker portfolio holdings (potentially with gains) and to take profits on shorter maturity bonds.”
A-rated munis with a 10-year maturity provided an extra yield of 78 basis points versus similar triple-A rated munis, Friday’s MMD data shows. Among one-year notes the extra yield was 44 basis points.
Single-A municipal debt is arguably still a safe-haven investment. Three decades of default data compiled by Moody’s Investors Service indicates A-rated munis have a better track record than triple-A rated corporates.
Some people still believe value can be found on the longer end of the tax-exempt curve. Daniel Berger, senior market strategist at Thomson Reuters, is recommending triple-A tax-exempts in the 20-year range.
The 20-year to 10-year spread among triple-A munis was 108 basis points Friday, versus an average of 88 basis points the past year, he noted. Against the average, this suggests 20-year bonds stand to outperform 10-year bonds by 20 basis points.
Meanwhile, retail investors wishing to escape low yields have been moving cash into mutual bond funds, according to Richard Ryffel, managing director at Edward Jones.
Inflows into the $2.5 trillion bond fund market were $28.6 billion in the four weeks ending Aug. 25 and $30 billion in July, according to the Investment Company Institute.
That represents a significant increase from average monthly inflows of $21.1 billion in the second quarter.
While bond funds are seeing inflows, the $4.9 trillion equity-based mutual fund market has experienced outflows for four straight months, including $18.5 billion the past four weeks.