The calm that has descended over the municipal bond market may last only as long as the current supply drought.
State and local government debt rallied the second half of January and seems to have settled down from the monstrous sell-off that lasted from November through the beginning of this year.
Intermediate yields were unchanged in light activity on Wednesday. The triple-A 10-year yield closed at 3.34%, according to Municipal Market Data, unchanged on the day and down 20 basis points from the middle of January.
But the tranquility comes amid favorable conditions: the lightest monthly supply in 10 years.
Many traders, bankers, and investors worry about a fragile market’s ability to absorb a substantial supply of new bonds, if it ever comes. That concern may be behind a minor snap-back in long-term yields this week. The triple-A 30-year municipal weakened four basis points on Wednesday, after weakening a basis point on Tuesday.
“We’ve just gone through the lowest supply of the century,” said a trader in Los Angeles, referring to the $12.2 billion of debt municipalities sold in January, the skimpiest monthly supply since 2000. “There’s certainly a little bit of concern about that. … If we get any spikes in supply it could become more difficult.”
Municipalities sold little debt in January for two reasons: one, the rush to sell taxable bonds under the federally subsidized Build America Bonds program last year pulled issuance forward; and two, the 100-basis-point spike in yields in the fourth quarter discouraged issuers that were considering coming to market.
George Friedlander, who heads municipal strategy at Citi, in a note earlier this week called January issuance “extremely sparse.”
According to Bloomberg LP, municipalities sold an average of almost $8 billion of debt a week in 2010. Supply for the first four weeks of January 2011: $938.4 million, $4.44 billion, $3.14 billion, and $3.3 billion.
Nor is the calendar threatening. The 30-day visible supply, which measures the stock of municipal bonds slated for sale in the next 30 days, is $9.4 billion. Municipalities came into this week scheduled to sell $3 billion.
The late-January rally notwithstanding, it remains to be seen how capable the market is of digesting much more than this.
The concern as Friedlander sees it is the latest stabilization was driven in large part by non-traditional crossover buyers such as hedge funds and life insurance companies, who were tempted into the market by high municipal yields relative to Treasury yields.
These buyers were able to soak up the scant tax-exempt supply that came to market the past few weeks. However, their appetite for tax-free debt only goes so far. Should tax-exempt supply outstrip the non-traditional municipal investor’s capacity to buy it, yields may have to drift up to bring traditional retail investors back into the market.
“The improvement has happened during a period of extremely light new-issue supply,” Friedlander said. “In the absence of substantially improved bond fund flows, it remains unlikely, in our view, that the support from crossover buyers, a handful of traditional institutional buyers such as property and casualty insurance companies, and the limited proportion of direct retail buyers that are willing to look at long maturities would be sufficient to absorb a more normal-sized new issue calendar without repricing the market toward higher yields.”
This expected repricing is exactly behind what happened to the long end on Wednesday, according to Thomson Reuters analyst Randy Smolik’s daily commentary. As crossover buyers have drifted back to the taxable bond sector because of higher yields there, dealers in tax-exempt bonds are trying to unload their long-term muni positions.
The hand-wringing over buyers at the long end has its roots in the conversion of mutual funds from buyers to sellers of long-term tax-exempt bonds starting three months ago. Municipal bond mutual funds have reported more than $31 billion of redemptions since mid-November, according to Lipper FMI. Fund managers seeking to raise cash to meet these redemptions have exerted substantial selling pressure on the muni market.
A Bloomberg index measuring bids wanted submitted by institutions reached a record $1.4 billion last year.
Some traders said the bids wanted submitted by mutual funds have subsided this week, indicating that either the outflows have slowed or the funds have already sold enough bonds to meet the anticipated redemptions.
Still, as long as mutual funds are losing cash, what has been the strongest source of demand for long-term tax-free debt the past two years will still be mostly absent from the primary market.
“If there are no inflows for the market, I’m not sure you have the buyers to absorb a significant change in supply,” the trader in Los Angeles. said. “We may have to have an adjustment in yields, and I don’t think anyone wants to go through that again.”
Most of the analysts who forecast municipal bond issuance expect a significant drop in bond sales this year from last year’s $433 billion slate.
Citi predicted $340 billion in issuance this year, Loop Capital forecast $375 billion, and JPMorgan forecast $325 billion, though the JPMorgan estimate is only for tax-exempt bonds.
Though the pace of deals has picked up since early last month, it remains far from a substantial test of the market’s ability to digest supply.
On Wednesday, the New York City Transitional Finance Authority priced its $775 million deal in the negotiated market. The bonds, which mature from 2013 to 2035, will carry yields from 0.87% to 5.2%.
Rated triple-A by Standard & Poor’s and Fitch Ratings, and Aa1 by Moody’s Investors Service, the longest maturity of the deal priced 46 basis points over the triple-A MMD scale. Goldman Sachs was lead underwriter.
In the competitive market, North Carolina sold $500 million of capital improvement limited obligation bonds, rated AA-plus by Standard & Poor’s and Fitch and Aa1 by Moody’s. Maturing from 2012 to 2031, the winning bids came in from Wells Fargo.
Though the longest maturity was not re-offered, the bid for the second-longest maturity — in 2030 — was 4.83%, or 26 basis points above the triple-A scale.
