The giant question mark of whether bankers will be able to find buyers for municipal bonds if and when they come in heartier supply continues to keep dealers sidelined, demand sickly, and yields drifting up.
Yields on triple-A municipal bonds Friday leaped by as much as five basis points for certain maturities, according to Municipal Market Data, with the benchmark 10-year yield up two basis points.
The 10-year yield, at 3.21%, has spiked 31 basis points since March 16.
Municipals delivered a total return of -0.6% in the second half of March, according to a $1.3 trillion Standard & Poor’s index.
It’s important to understand that this poor performance comes during a major supply drought. Municipalities sold just $2.4 billion of bonds last week, to close out the lowest quarterly issuance in 10 years. They are slated to sell $3.3 billion this week. The market is having trouble placing even this small amount of debt.
It is unclear how much demand there is for tax-free municipal bonds. Until the market finds out, buyers see no need to reach and sellers see no need to concede.
“So many reasons just to sit on the sideline and do nothing,” said a trader in California. “The buyers and most of the sellers see it the same way.”
This trader expects “a much different market” in a month and a half, when supply finally picks up.
“Traders are going to be hurting,” he said.
The stasis that is keeping yields from adjusting higher for now was thoroughly outlined in a report on Friday by Michael Zezas, who heads municipal research at Morgan Stanley.
We’ll have to paraphrase most of the six-page report, but here goes:
Demand is weak. Investors think yields are too low and don’t want to buy at these levels.
Normally, that would force sellers to cut prices to entice buyers. But with so few bonds coming to market, dealers have no impetus to slash their asking prices.
The combination of low demand, low supply, and dealers’ reluctance to offer concessions leaves the market in a weird stalemate. What remains is “a market with no conviction in current valuations, but with little incentive to sell bonds,” Zezas wrote.
What can jolt the market out of its stalemate?
Municipalities will not stay out of the market forever. The economy is growing; municipalities need to replace equipment and finance projects. While Zezas slashed his forecast for municipal borrowing in 2011 to $270 billion from $375 billion, he still thinks municipal bond issuance will grow by more than a third in the second quarter from the first quarter.
The increase in issuance will “almost certainly” force rates up to tempt enough buyers, Zezas said.
His conclusion? Avoid long duration for now. The tax-exempt yield curve will probably have to steepen to clear new-issue volume, he said.
Could Zezas be wrong? He conceded that if retail investors turn out to exhibit more appetite for tax-free bonds than expected, demand could meet a greater amount of supply.
He doesn’t think that’s the case, and neither do we. The retail investor not only had a great deal of difficulty absorbing last year’s tax-exempt supply, which was only about $275 billion, he even had some trouble absorbing this year’s anemic first-quarter supply. When yields in the first quarter reached extraordinarily high levels, we heard about some retail interest, but mostly it was life insurance companies and hedge funds. If retail investors are ready for more tax-exempt supply, where were they in January when the 30-year triple-A muni yield exceeded 112% of the 30-year Treasury yield?
