NEW YORK – The tax-exempt market ended the week on a soft note as two days of weakening erased two weeks of gains.
The week started out very strong, with muni yields breaking record lows each day. But by Thursday, the rally halted and munis continued to weaken Friday.
“If the music was slowing down, Friday it stopped,” a New York trader said. “Dealers who have been long munis throughout this rally, endeavored to preserve some profit by putting items out for the bid in the brokers’ market.”
He added, “For some, even with significant upward adjustments in yield to the scale and the wider bid-offer spread, there were still profits to be had.”
Another New York trader said “There is a good amount of bids-wanted out early and plenty of price cuts. There is a little bit more size next week. I’m interested to see how those are received.”
Munis weakened Thursday and Friday after strengthening since 2012 began. On Friday, yields finished up two to 10 basis points across the curve. The 10-year and 30-year yields finished up nine basis points each to 1.83% and 3.34%. The two-year closed steady at 0.35% for its sixth consecutive trading session.
The losses on Thursday and Friday erased all gains made on the 10-year and 30-year since Jan. 6.
Treasuries fell toward the end of the week, and on Friday, the benchmark 10-year yield finished up six basis points to 2.04% and the 30-year yield closed up seven basis points to 3.11%. The two-year year was steady at 0.25%.
In the secondary market, trades reported by the Municipal Securities Rulemaking Board showed weakening Thursday and Friday.
Bonds from an interdealer trade of Massachusetts School Building Authority 5s of 2041 yielded 3.64%, 24 basis points higher than where they traded Wednesday – the first day munis were weaker in 2012.
Bonds from another interdealer trade of New York Liberty Development Corp. 5s of 2041 yielded 3.87%, 22 basis points higher than where they traded Wednesday.
A dealer sold to a customer California 7.6s of 2040 at 5.37%, 13 basis points higher than where they traded Wednesday.
Bonds from an interdealer trade of Los Angeles County Sanitation District 4.5s of 2038 yielded 4.57%, five basis points higher than where they traded Wednesday.
And while munis are showing weakening in the near term, one investor thinks demand for munis should be strong and strengthen in the long-term.
Ron Schwartz, director of tax-exempt portfolio management at StableRiver Capital Management, said munis should see strong demand because they continue to be one the most secure asset classes.
Among investment grade muni bonds rated by Moody’s Investors Service from 1970 to 2009, the ten-year cumulative default rate was 0.06%, 42 times lower than the average cumulative default rate for corporate borrowers rated by Moody’s during the time period.
Schwartz also said demand for muni bonds in 2012 should increase due to default forecasts that never came to fruition. “Dire predictions of municipal defaults and bankruptcies for the 2011 year plagued forecasts, resulting in a markedly downward shift of municipal demand,” Schwartz wrote. Looking to 2012, Schwartz said that “while credit pressures in the municipal market are sure to continue for the foreseeable future due to sluggish revenue growth, federal spending cuts and unfunded long-term liabilities, the vast majority of municipal issuers are likely to weather the storm.”
Another year of low issuance along with fears coming from the Euro-zone debt crisis should push demand for munis higher as well. “With overall municipal supply likely to remain under pressure during the year, further investor flight-to-quality would likely increase the attractiveness of municipal bonds as an asset class,” he said.
Bush-era tax cuts that are set to expire at the end of 2012 also bode well for munis as the highest income earners will see taxable incomes increase to 39.6% from 35%. “This change in tax rate would increase the value of the municipal tax exemption by the same increment,” Schwartz said.
