Issuance in the municipal bond market hit a record high for the first half of 2005 as tax-exempt borrowers took advantage of low interest rates and a flattening yield curve to issue a wave of refundings.
As of June 30, issuers sold $209 billion in municipal debt, a 10% year-over-year increase, just narrowly surpassing the previous record of $205.9 billion that was sold in the first half of 2003, according to Thomson Financial. The number of issues brought to market in the first half of the year increased by 2%, to 7,124 from 6,965.
The reason for the surge of issuance is quite clear: the favorable interest rate environment. The primary reasons for issuance has been low interest rates and the flattening yield curve, said Matt Fabian, the senior municipal research analyst for UBS Financial Services Inc.
While record low interest rates have been the norm for the past couple of years, the shape of the yield curve, or the difference between long- and short-term rates, has narrowed considerably since 2003. For the first half of 2005, the average difference between the yield on a one-year note and a 30-year bond was 197 basis points, according to Municipal Market Data. In 2003, that spread was 360 basis points, creating a much steeper curve. A flatter yield curve is more conducive to refunding activity as it reduces the issuers' cost by making the advance refunding process more efficient.
Refunding activity rose more than 60% and represented more than a third of issuance for the first half of 2005, while new money-issues - still more than half the total volume - actually fell 6% from the same period in 2004. Some analysts say the decline may simply reflect the very high level of issuance in previous years and the seasonalities in the muni market.
Of the issues that were brought to market, the biggest increases came in the education, development, and transportation sectors. Only issuance of general purpose bonds were down from the 2004 level, registering a decline of 17.2%.
One significant difference from last year, however, was the increase in issuance of variable-rate debt and the use of swaps as a means of containing costs. Variable-rate debt issuance jumped to $28.9 billion, a 51% increase from the previous year. In many instances, issuers have used variable-rate debt and a swap to create a synthetic fixed-rate obligation while still availing themselves of the benefits of a variable-rate loan.
Swaps are contracts, not securities. Their growth is not tracked statistically, but anecdotally it appears the use of such products has increased significantly. While the expectation of rising rates may have played a role in the popularity of swaps, demand for such transactions may also be due to increased sophistication on the part of tax-exempt borrowers.
While these types of transaction are more popular in a rising rate environment, I think we are seeing a secular trend where borrowers have become more comfortable with this type of transaction, Fabian said.
So what's in store for the second half of '05? Much depends on how interest rates behave.
As long as interest rates continue to be low, issuance should remain at the same pace, said John Lonski, chief economist at Moody's Investors Service. But the shape of the yield curve could also provide some clues to the rate of future issuance.
If the yield curve were to continue to flatten, refunding activity could pick up, Fabian explained. But if the shape of the curve were to stay the same, I suspect that the pace should taper off. There is only a finite capacity to get deals done at the current curve shape.
The difference in short- and long-term rates has narrowed despite the fact that the Federal Open Market Committee has raised the federal funds rate nine times since June 2004. Lowered expectations for inflation have created unexpected demand for long-term bonds, and that - combined with the Fed's monetary policy - has created a window of opportunity for many state and local governments to refund previous debt obligations. Fears that the current rate structure is changing may prompt many tax-exempt issuers to expedite any refunding plans while the environment remains favorable, according to a recently published Lehman Brothers report.
One sector that could see an increase in issuance for the rest of the year is tobacco. After a series of favorable rulings for the industry, investors' fears of increased litigation risk have started to subside. So while tobacco debt has typically been viewed as a volatile area of the tax-exempt market, investors' newfound appetite for Master Settlement Agreement-backed bonds has created an opportunity for many states to refund their existing tobacco debt.
With yields currently low, many states are taking advantage by refunding previous issues, according to one dealer. Although it is difficult to predict how future litigation risk may affect demand, currently investors' desire for tobacco credits remain high.
People have started to realize that big tobacco almost always wins every large case brought against them, said B. Clark Stamper, president of California-based Stamper Capital Investments. These bonds should never have gotten as cheap as they did. The states should be issuing like crazy because the spreads are so tight right now. You should see a flood of refunding, or even a wave of new securitization.
Jill D'Ambrosio contributed to this story.
