Municipals Continue to Weaken in Buyer-Seller Standoff

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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 negative 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; state and local governments 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 muni 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, according to Zezas.

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?

For that matter, with the 30-year triple-A yield currently at 107% of the Treasury yield, where are they now?

Mutual Funds

Today we conclude our series on the various types of investment demographics, and why long-duration tax-free bonds are unsuitable for each of them.

Banks and property-casualty insurance companies are trying to immunize liabilities with durations far shorter than long-term tax-exempt municipal bonds.

Life insurance companies, pension plans, endowments, and foundations have the appetite for longer duration, but their low- or no-tax status makes tax-exempt muni rates uncompetitive with corporate or sovereign debt.

Wealthy retail investors will sometimes go out into long maturities, but given their vulnerability to inflation they generally prefer to keep their holdings in short to intermediate maturities.

This brings us finally to mutual funds. With $467 billion in assets, municipal bond mutual funds are the one major demographic of the buy-side with an appetite both for long duration and the tax exemption.

The average duration of municipal bond mutual funds is 7.2 years, according to Morningstar, well-positioned to absorb long-duration municipal bonds. Funds described by Lipper FMI as “long” hold $271 billion of assets.

We found a dozen mutual funds with more than $1 billion of assets and an average duration of more than 10 years. These funds collectively hold $43.4 billion of assets.

Great. So the market has found its savior. Mutual funds are the marginal buyer of long-duration tax-free bonds, and we’ve wasted our time and yours by spotlighting all the other types of investors that avoid the long end of the tax-exempt curve.

Except for one thing: mutual funds have not been buying long-term tax-free bonds for about five months now. They’ve been selling long-term municipals at a really alarming rate.

The spillage of cash out of muni bond mutual funds since November is disproportionately attributable to outflows from long-term funds. While all municipal funds have reported $43.7 billion of outflows, long-term funds have accounted for almost $30 billion of that.

The long-term fund category’s assets have shrunk by 14% since early November. This is not a segment of the investing universe that is ready to absorb long-duration tax-free debt. Quite the opposite: it’s been dumping tax-free debt onto an unwitting market for five months.

In fact, mutual funds provide a great illustration of why many people avoid duration in the first place. During periods like the fourth quarter of 2010, it’s the holdings with the longest duration that perform the worst.

To highlight this, we offer the inglorious fourth quarter reported by the Eaton Vance National Municipal Income Fund, the muni bond mutual fund with the longest duration.

The $4.5 billion fund is a fiend for duration. There are two primary ways to increase the duration of a fund: buy longer-maturity bonds, and buy zero-coupon bonds. The Eaton Vance national fund has done extensive work on both of these fronts.

More than 26% of the fund’s bonds mature in more than 30 years, which is nearly double the category average, according to Morningstar. Almost 14% of its holdings are zero-coupon bonds, which are generally the longest-duration type of security because they defer all the cash flows until the maturity date.

The fund’s biggest holding is a $67.5 million Puerto Rico Sales Tax Financing Corp. zero-coupon bond maturing in 2054. The roughly $685 million of zero-coupon bonds in the Eaton Vance fund mature in an average of 27 years.

This strategy has endowed the fund with an average duration of 14 years. A duration of that magnitude means the fund will gain twice as much value as the average municipal bond fund when interest rates fall — and lose twice as much value when interest rates rise.

Heaping on so much duration has helped the fund trounce its benchmark most quarters the past few years.

In the seven quarters from the beginning of 2009 through the third quarter of 2010, the Eaton Vance fund’s return beat its benchmark as well as its category average five times. In the first quarter of 2009, the fund beat its benchmark by 1,035 basis points.

In the fourth quarter of 2010, investors learned the price of such outperformance in good times. The fund returned negative 9.7% for the quarter, underperforming its benchmark by more than 550 basis points.

The fund has now delivered a negative total return over the past three years, underperforming its benchmark by 568 basis points during that time. While it’s in the top third performers of funds over the past 10 years, it’s been in the bottom 2 percentile over the past three years.

We’re not arguing against duration. We’re simply pointing out that the additional return it offers is not free.

The ugly reality facing the municipal finance market today is that it’s run out of ways to ignore that.

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