NEW YORK – With no supply to provide direction, the tax-exempt market followed Treasuries higher as munis continued their fifth consecutive trading session of gains.
“There is still no supply and Treasuries are up huge so everyone is grabbing for bonds today,” a Chicago trader said. “Bottom line is there is just a real drought with any kind of new offerings so we are going to stay firm as Treasuries rally.”
Munis rallied Monday as prices were bumped across the curve, according to the Municipal Market Data scale. Yields on the two-year to four-year fell two basis points while yields on the five-year to seven-year fell three to five basis points. Outside eight years, yields plunged six to eight basis points.
The 10-year muni yield fell seven basis points to 1.70%, the lowest level since Jan. 18th when the 10-year muni yield set a record low at 1.67%. The 30-year yield also fell seven basis points to 3.16%, its lowest since the record 3.15% set Jan. 18. The two-year muni yield fell two basis points to 0.33%, its lowest since Sept. 27th.
“These bumps seem just a bit exaggerated, almost entirely based off of the Treasury move this morning,” said a New York trader. “Then again, it is Monday and supply this week still seems tight so the bumps may be warranted, just a bit early.”
Treasuries rallied to levels not seen since Jan. 18th. The benchmark 10-year yield fell five basis points to 1.85% while the 30-year yield dropped seven basis points to 3.00%. The two-year was steady at 0.22%.
And while munis seem to be getting off to a good start this week, it is nothing compared to the rally munis have experienced so far this year.
The municipal bond market had a terrific January, on both a nominal as well as a relative basis, as the market continued its trek out of the wilderness that dominated the first part of 2011,” said John Mousseau, head of tax-free munis at Cumberland Advisors. “The spark that set this rally off was the usual year-end supply distortion, with an estimated $35 billion of coupon payments, called bonds, and maturing bonds in the combined months of December 2011 and January 2012.”
With fairly low nominal yield levels, Mousseau said he is starting to shorten durations and maturities. “We are starting to add more short-term bonds, cushion bonds, and municipal inflation-indexed bonds. These low yields should spur on issuance later in the year and we feel that continued economic growth, while slow, should result in overall higher yield levels later in 2012.”
The primary market was quiet Monday. But in the secondary, trades reported by the Municipal Securities Rulemaking Board showed firming in the last trading day.
A dealer sold to a customer California 7.3s of 2039 at 5.27%, 19 basis points lower than where they traded Friday.
Bonds from an interdealer trade of Sharyland, Texas, Independent School District 5s of 2025 yielded 2.24%, 12 basis points lower than where they traded Friday.
Bonds from another interdealer trade of Massachusetts School Building Authority 5s of 2041 yielded 3.42%, 10 basis points lower than where they traded Friday.
A dealer bought from a customer Massachusetts 5.25s of 2025 at 1.58%, 4 basis points lower than where they traded Friday.
Munis have gotten more expensive on the short-end as muni-to-Treasury ratios on the five-year and 10-year have increased. Over the past week, the five-year ratio jumped to 98.7% from 91.2% and the 10-year ratio has risen to 93.7% from 90.8%. Ratios on the long-end have fallen as munis outperformed Treasuries. The 30-year muni-to-Treasury ratio fell to 105.6% from 107.3% the week prior.
The yield curve has fallen significantly in the past week. On Friday, the 10- to 30-year slope fell to 146 basis points from 150 basis points the week prior.
“This is notable because this slope has exhibited a slow, but steady, decline since the beginning of January when it began the year at plus 169 basis points,” wrote MMD’s Daniel Berger. “Perhaps this is attributable to the Fed’s operation twist policy step, which is only about halfway through. Should it continue, it will put downward pressure on long-term interest rates.”
The sensitive balance of supply and demand has been extremely off kilter as of late as demand has far outweighed supply. Analysts at Citi expect retail demand for munis to continue while demand from institutional investors may not be as strong. “We expect to see continued strong retail demand for munis due to the massive, inexorable collapse in yields on short-term instruments and cash equivalents, and the massive amount of cash in individual investor hands,” wrote George Friedlander.
Institutional investors, such as property and casualty insurance companies have cut back on their tax-exempt holdings in the past few years and may continue to do so. “The large number of expensive disasters in the U.S. in 2011 hurt earnings, and again reduced the capacity to own munis at a number of insurers,” Friedlander said.
However, commercial banks were strong buyers of munis in 2011 and should continue to buy in 2012. “The reason for this pattern is relatively straightforward: the high yield on intermediate and long-term munis relative to their incremental cost of funds, largely in the CD market,” Friedlander said.
Looking ahead to Tuesday, the biggest deal on the calendar comes in the competitive market. Washington is expected to auction $960 million of general obligation bonds in two pricings: $700 million of various purpose GO refunding bonds and $260 million of motor vehicle fuel tax GO refunding bonds.
While the bonds are rated AA-plus by Fitch Ratings, the auction comes only days after the outlook was revised to negative from stable.
The revised outlook “reflects the challenges faced by the state in addressing a sizable budget gap,” wrote Laura Porter, managing director at Fitch. “The state is operating in an environment of significantly constrained revenue raising and spending control flexibility. Maintenance of the AA-plus rating will be contingent upon enactment of sustainable budgeting measures that provide an adequate cushion against future revenue underperformance.”