Muni Yields Take a Surprising Direction

So much for a slow week between Christmas and New Year’s.

The 10-year muni yield set a new record low as recorded by Municipal Market Data as munis rallied across the board, following Treasuries. The new 10-year record, now 1.87%, broke the previous record of 1.91% set the week before Christmas.

At the end of the day, one trader in New York said that “dealers are playing with rollover money” and are “getting ahead of the curve.”

“Muni sellers were anxious to bump offerings in the face of a strong Treasury rally that erased losses since last Thursday,” said MMD’s Randy Smolik. “With Wednesday being the first regular settlement day in January 2012, buyers had reason to reach.”

Throughout Wednesday, munis traded firmer, as year-end buyers buoyed tax-exempts.

“We are pretty busy here,” the New York trader said. “Buyers are looking for bank-eligible paper. It seems like banks have some cash to spend in the new year.”

“Offering levels are showing little give, with expectation of strong demand as the new year rolls in,” wrote Alan Schankel, managing director at Janney Capital Markets, adding that January redemption flows are expected to come in between $20 billion and $25 billion.

Indeed, munis spent Wednesday rallying, according to the MMD scale. Yields inside the three-year were flat, while yields on the four-year fell two basis points. The five-year to eight-year yield fell three basis points and the nine-year to 23-year yields dropped four basis points. Outside the 24-year, yields plummeted five basis points.

On Wednesday, the two-year yield closed flat at 0.36% for its 15th consecutive trading session. The 10-year yield fell four basis points to 1.87%. The 30-year yield dropped five basis points to 3.58%.

Treasuries had a bigger rally. The two-year yield fell two basis points to 0.28%. The benchmark 10-year yield dropped nine basis points to 1.93% and the 30-year yield plunged 12 basis points to 2.92%.

Still, some traders noted it was a relatively quiet week overall.

“It’s very quiet,” a second trader in New York said. “Half of my sales coverage has a 'red dot’ next to their names on Bloomberg.”

“It is a trade-by-appointment week,” he said. “The lack of new issues does support the bid side somewhat, even though it’s pretty thin, but I wouldn’t want to be the guy that suddenly has a portfolio to liquidate before year-end.”

While the primary market is mostly shut down for the week, the secondary is trying to take over. Trades reported by the Municipal Securities Rulemaking Board showed firming.

Bonds from an interdealer trade of New York Liberty Development Corp. 5s of 2041 yielded 4.21%, eight basis points lower than where they traded last week.

A dealer bought from a customer New York City Municipal Finance Authority 5s of 2044 at 4.13%, four basis points lower than where they traded last week.

A dealer sold to a customer Virginia Public School Authority 5s of 2022 at 2.26%, two basis points lower than where they traded the previous week.

Bonds from an interdealer trade of Detroit Water Supply 5.25s of 2041 yielded 5.26%, two basis points lower than where they traded last week.

“Buoyant Treasuries were making secondary muni offerings a little prouder,” Smolik wrote. “As the taxable market firms, we find the muni secondary more nervous about losing inventory before the new year than preferring to work down positions. Thus, the path of least resistance for the muni market currently seems to be to lower yields.”

Looking forward to Thursday, the competitive market can expect $229.5 million of Municipal Electric Authority of Georgia revenue bonds in four series.

The first series includes $100.73 million of taxable power revenue bonds. The second series includes $81.24 million of taxable general resolution projects subordinated bonds, and the third series is $59.53 of taxable project one subordinated bonds. The last series will be $57.98 million of taxable general power revenue bonds.

Munis were the highest-performing sector among the fixed-income classes in 2011. Into 2012, some expect the high return from muni bonds to continue.

Much of the outperformance of munis in 2011 can be attributed to the fact that munis are a longer-term asset class than the broader fixed-income market, according to analysts at Trident Municipal Research.

Because of the long-term structure, muni debt is somewhat protected from the immediate impacts of the Euro-zone crisis.

“This longer maturity profile is also one of the sources of the credit safety of U.S. state and local debt because it reduces the cliff risk facing Euro-peripherals such as Greece and Italy,” Trident analysts wrote.

Outperformance of munis in 2012 could also continue as long as outperformance is because of coupon income.

“Roughly 44% of this outperformance came from coupon income — not surprising, given that municipal yield ratios relative to Treasuries have remained above 100% and that longer maturities tend to yield more than shorter maturities,” the analysts wrote. “So the outperformance should not be interpreted to mean that the potential for further outperformance has been exhausted.”

With absolute yields so low, many market participants look at muni-to-Treasury ratios to find value. One New York trader said when ratios were above 100% on the short end, “that’s where we were seeing trading.”

Ratios spiked in 2011, with the 10-year ratio jumping to 128% in October after a low of 82% in May. Analysts at Morgan Stanley Smith Barney said it is “unlikely” municipal ratios will experience that kind of volatility in 2012.

The market is expected to price in the fact that the tax-exemption of munis will be up for discussion again by policy makers in 2012. “We view this new and uncomfortable reality as a headwind for driving 10-year relative value much below 95% of corresponding Treasuries,” John Dillon at Morgan Stanley Smith Barney wrote.

One pattern he said he expects to continue into the new year is “the tendency and ability of municipals to underperform Treasuries during price advances and outperform during periods of price declines or near-term price stability.”

On Tuesday, the 10-year muni-to-Treasury ratio closed at 95%. The five-year ratio finished at 93.8% and the 30-year ratio closed at 119.4%.

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