The municipal market adopted a serene pose Thursday, reclining on a chaise lounge and slowly fanning itself. With a holiday weekend upon it and few traders around to answer their phones, the market clearly was in no mood for a dramatic rally or sell-off.
“The market is practically unchanged,” a trader in New York said. “There was really light activity. The three-day weekend started today, if not earlier.”
Tax-exempt yields were unchanged through the first eight years of the curve Thursday, according to the Municipal Market Data scale. For maturities beyond 2019, they were one basis point lower.
The benchmark 10-year yield on Thursday ticked down another basis point to 2.24%. The 30-year yield also dipped a basis point to 3.88%.
The two-year yield remained unchanged at 0.30% for a 17th straight session, hovering at its lowest level in more than 40 years.
Treasury yields, meanwhile, saw the approaching holiday and mediocre economic data as cause for a rally across the curve. The 10-year benchmark yield plunged 10 basis points on the day to 2.14%.
The 30-year yield plummeted 11 basis points to 3.50%. The two-year yield slipped two basis points to 0.19%.
At this point in the week, new issuance is mostly finished. And while the week preceding Labor Day is typically low, this one has been disappointing, though not surprising.
According to industry estimates, municipal bond sales for this week should total a paltry $1.2 billion, compared to a revised $4.4 billion last week. No new issuance of any significance is expected to hit the primary market through Friday.
That should soon change for the better, lest anyone worry, according to John Dillon, chief municipal bond strategist for Morgan Stanley Smith Barney. “Look at the 30-day visible supply and it doesn’t seem problematic at all,” he said. “I expect to see a mild ramp-up in issuance in September, but it doesn’t seem ominous at this point. And frankly, we need the issuance for price discovery.”
Beyond new issuance of munis, Dillon added, the tax-exempt market is in a different place in 2011 than it was at this point last year. For one, issuance of Build America Bonds, arguably the biggest story for the market in 2010, is only a fond memory today. In addition, investor anxiety about municipal credit, which materialized in a big way in September, has declined dramatically.
Some things haven’t changed, though. The Treasury market is still hinging on whether there will be QE3, just as it was pondering QE2 a year ago, Dillon said. And the muni market is still data-dependent and Treasury-dependent.
“Standing where rates are now, it seems you’d need a consistent diet of downbeat economic data to keep you at these levels, or lower,” Dillon said. “So, the big risk for munis now is rate risk, not credit risk.”
In another assessment of the marketplace, Tom Kozlik, municipal credit analyst for Janney Capital Markets, wrote in a recent report that the firm expects support for munis’ tax-exempt status to prompt debates, but ultimately to remain a fixture as an option for funding.
Janney predicts that in the short term, any federal deficit reduction’s effect on muni credits will be subdued. “Although the tone seems dire at the moment,” Kozlik wrote, “the U.S. government does have a history of political compromise and a legacy of supporting the municipal sector, especially states and local governments.”
Over the medium term, Janney expects primary issuance in the market below historical averages, high trading volatility, wider spreads, and lingering question about the future of tax-exemption. The firm also anticipates continued political support for the municipal market through such programs as a rebirth of Build America Bonds and bond-qualified expansion.
“We do believe significant tax-reform changes could occur, but that tax-exempt funding for state and local governments and some private-activity bond issuers will remain,” Kozlik wrote. “This will be at the expense of certain types of conduit financings, which are not considered to be a priority such as those sold by corporations, for example.”
Analysts such as Kozlik also see some opportunities for relative value to investors in today’s environment. One includes tax-exempt bonds backed by corporate credits.
To begin with, tax-equivalent yields on many of the issues remain well above their taxable corporate brethren. Therefore, many tax-exempt bonds sold by corporate issuers remain attractive on a relative-value basis.
A primary reason for this is because many corporations have billions of dollars of taxable corporate debt outstanding, against a small amount of tax-exempt municipal debt. Taxable corporate bonds typically trade more frequently, trade in much larger block sizes, and are usually considered more liquid, Kozlik wrote.
“Consequently, the corporation’s tax-exempt debt could have a liquidity penalty factored into its return,” he added. “This is an arbitrage opportunity investors should take advantage of.”