Hedge funds and other non-traditional buyers will exit the municipal market place if munis continue to grow more expensive relative to Treasuries, BlackRock said.
"Before, when ratios were high, we had crossover buyers [in the muni market], and they mitigated volatility," Peter Hayes, managing director and head of the municipal bonds group at BlackRock, said at a breakfast in New York. "If the market keeps shrinking crossover buyers will sell and probably not come back. Retail will have to come back in and support the market."
Crossover buyers entering the municipal market during the 2008 financial crisis when ratios between the triple-A 10-year benchmark general obligation bond and the 10-year treasury widened to as much as 186.06 basis points on Dec. 18 of that year, according to Municipal Market Data Interactive.
Ratios have compressed as the economy has improved, and have tightened this year in particular as low supply has allowed the few bonds that do come to market to come at rich prices. Ratios have tightened by 6.56 basis points to 86.97 basis points on June 4 from Jan. 2 of this year. That ratio is 99.09 basis points tighter than the 2008 peak.
"If we continue to get very, very low issuance, if the market continues to shrink, ultimately demand will force prices higher, yields much lower, and that relative value relationship will change and crossover buyers will exit," Hayes said.
BlackRock anticipates that issuance won't decrease from current levels in oncoming years. Volume as of May 31 totaled $115.15 billion compared to $153.03 billion for the same period in 2013, according to data provided by The Bond Buyer and Ipreo.
"I think issuance going forward is going to remain in the area of $275 [billion] to $325 billion; that seems like the home for muni issuance going forward," Sean Carney, municipal strategist at BlackRock, said.
Carney said BlackRock projects issuance will remain in these levels because, as the economy recovers and the gross domestic product number increases, municipalities will be able to spend more freely.
"As GDP increases local budgets will be less constrained, and given our view that rates will not substantially increase in the near term, the prospects for consist if not slightly great issuance will form," he said.
Hayes said that while crossover buyers haven't been as active during the recent municipal bond rally, he does not see them leaving the market in the immediate future because they still need for long-duration fixed income assets.
"I don't think crossover buyers will [exit the muni market] for a while," Hayes said. "Part of the problem is, as evidence of this, you can look at the long US treasury market. There is just less long duration fixed income assets being created and there seems to be a growing need for it from a variety [of investors], whether its sovereign central banks, insurance companies pension funds etc., so I don't think we are close to that point yet."
Janney Capital Markets is less optimistic about issuance remaining between $275 billion and $325 billion in oncoming years. Tom Kozlik, municipal credit analyst at Janney, wrote in a report released on May 22 that issuance will be between $225 billion and $227 billion in 2015. He wrote that it would drop down to the $175 billion to $225 billion range in 2017.
"Only a change in attitudes and a reprioritization of spending on infrastructure, and investing for the future is likely to increase issuance," Kozlik wrote. "These are tremendous barriers to overcome without a crisis or other incentives."
