Market Close: Playing Catch-up With Treasuries, Muni Short End Hammered

Weakness at the five-year part of the municipal bond curve set the tone for the tax-exempt market as it spent Thursday's session catching up to Treasuries.

Traders reported muni bonds maturing in 2018 increased up to five basis points in yield on the day. Even so, municipals in that range haven't seen the rise equivalent maturity Treasuries have, a trader in San Francisco said.

The part of the muni yield curve around five years had been among the most expensive when compared to Treasuries, with ratio percentages in the upper 70s — 79% at Wednesday's close. Investors who had bought five-year munis, seeking credits that were less sensitive to a rise in interest rates, paid the price Thursday, the trader added.

"We were playing catch-up a little bit with what was happening in the Treasury curve yesterday," he said. "And again, today, we saw a big flattening in the Treasury curve, and so we saw that start to play through in the municipal market."

Activity in the one- to five-year part of the yield curve may have opened investors' eyes, the trader noted. They may now be prompted to look even shorter term.

"That's probably the area of the curve that, on a relative basis, is most vulnerable," he said. "So, you might see guys pulling out of the one- to five-year space to go even shorter, into the floating-rate- or money-market area for a while, until they feel interest rates have stopped going up."

The upward movement of Treasury yields in response to the Federal Reserve's announcement to begin tapering its bond buying tugged municipals higher as Thursday's session pushed into the afternoon.

Muni yields also rose in the late-intermediate part of the yield curve, a trader in Chicago said.

"News of the tapering got the stock market all wild and crazy [Wednesday], and bonds are off a bit," he said. "People are trying to posture a bit for the end of the year. If you've got to get something done, it'll cost you to do that, and if you want to get something done, it's going to cost you, as well."

All told, the residual effects from the Fed news have pushed munis, though not as dramatically as Treasuries. The Federal Open Market Committee announced Wednesday it would cut the rate of its purchases of longer-term Treasuries and mortgage-backed securities to $75 billion per month from $85 billion per month.

Participants attempting to raise cash Thursday did so at their peril, the San Francisco trader said. Few bid-wanteds generated follow-through by traders. Puerto Rico paper, mostly general obligation bonds, traded as much as three basis points higher Thursday, he said.

Trades in the secondary market were weaker on Thursday, according to data from Markit. Oklahoma City Water Utilities Trust revenues 4s of 2024 jumped seven basis points to 2.92%.

Forsyth County, Ga., School District general obligations 5s of 2023 and Washington State Higher Education Facilities Authority revenues 5.25s of 2043 each rose three basis points to 2.75% and 5.32%, respectively. Pennsylvania GOs 5s of 2026 and San Mateo, Calif., Union High School District 5s of 2041 each climbed two basis points to 3.45% and 4.61%, respectively.

In addition, industry watchers anticipated a far lighter load of new issues on the week. Potential muni volume fell to an estimated $2.59 billion, compared with the hefty $10.63 billion of sales that arrived last week. The week's largest issues have already priced and the market has largely closed up shop for 2013.

Industry pros anticipate a 30th straight week of outflows from weekly reporting muni bond mutual funds when Lipper FMI announces numbers Thursday afternoon.

Regardless, there are still positive signs Citi muni analyst George Friedman noted in a research report.

Interest rates that remain close to cyclical highs eliminate pressure and will keep supply down for the remainder of the year. Those same higher yields will dampen issuance in 2014, as well, he said, to roughly $285 billion, keeping supply manageable.

Retail demand has become increasingly robust recently, Friedlander said. And munis' exemption from the Volcker Rule's prohibitions on dealers trading their own securities helps maintain liquidity in the marketplace.

Finally, investors may be reconsidering their view on how the tapering of the Fed's bond-buying program would raise long-term yields considerably, according to Friedlander.

"The bond market is sending signals that this is the case," he said, "as strong economic indicators and a resultant potential for the taper to start soon haven't sent long-term rates any higher."

Yields on the Municipal Market Data triple-A scale Thursday rose as much as four basis points across all but the front of the curve. They moved highest between five and 11 years on the curve.

The triple-A, tax-exempt 10-year closed Thursday four basis points higher at 2.75%. The 30-year rose two basis points to 4.18%. The two-year yield held at 0.33% for a 25th consecutive session.

Yields on the Municipal Market Advisors benchmark triple-A scale weakened mostly beyond three years on the curve by as much as four basis points. The 10-year rose three basis points to 2.77%. The 30-year increased two basis points 4.42%. The two-year held at 0.36%.

Treasury yields increased across the curve Thursday, continuing on an upward trajectory since Wednesday. The benchmark 10-year yield jumped five basis points to 2.94%, while the two-year climbed three basis points to 0.37%. The 30-year yield inched up one basis point to 3.91%.

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