Munis Fade Over Capacity Fears

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Municipal debt continued its steady fade Thursday as lingering concerns about the market’s capacity to soak up whatever supply might be coming later this year kept people from bidding on bonds.

Evidence of weakness is everywhere. Municipal Market Data has pushed the yield on the 10-year triple-A municipal scale up 29 basis points in the past 11 trading sessions, including four basis points on Thursday.

The weekly average yield to maturity on The Bond Buyer’s 40-bond index rose 5 basis points this week to 5.69%. The Bond Buyer’s 20-bond index rose nine basis points to 5% this week, while the 10-year Treasury yield rose only four basis points.

Even in the midst of a severe supply drought, new deals coming to market are not finding a receptive audience. Earlier this week, the Sunshine State Governmental Financing Commission floated a $247.6 million revenue bond with a 10-year maturity priced at a yield of almost 5%, more than 70 basis points higher than the single-A scale at that maturity. An insured piece of the bond maturing in 10 years priced to yield about 70 basis points more than MMD’s insured scale at that maturity.

“Right now it’s a fight out there,” a trader in New York said.

The latest MMD bull-bear survey found that 57% of traders are bearish, the most pessimistic outlook since Dec. 10 — a time when yields were in the process of skyrocketing.

One dynamic that might be draining some liquidity from the market lately is dealer behavior at the end of a turbulent quarter. During a period when yields are drifting up every day, dealers are hesitant to buy bonds and then get stuck with them just as the quarter ends.

As usual, the saving grace is an utter lack of issuance. The first quarter was the lightest quarterly issuance since 2000, according to Thomson Reuters. People are talking more and more about looming supply, but it hasn’t shown up yet. The Bond Buyer’s 30-day visible supply shows just $6.3 billion of municipal bonds for sale over the next month.

“We’re hearing more talk about it, but we’re not seeing it,” said a trader in California. “It’s a hovering concern, but the reality out in the marketplace is we’re not really seeing that buildup yet.”

Nonetheless, this trader said, if people think supply is coming and behave accordingly, they may be hesitant to stock bonds ahead of new bonds they believe are coming.

Hedging

The end of a quarter during which annualized volatility on the 30-year triple-A municipal reached nearly 30% seems like a convenient time to visit the question of how difficult it is to hedge a muni bond position in the current environment. The answer: really difficult.

We’ve heard a number of dealers carping lately about how the impracticality, if not impossibility, of protecting an inventory of tax-free bonds against a decline in value hampers liquidity. Nobody wants to take on bonds that are susceptible to shifts in rates when hedging against those shifts is impracticable.

The talk everywhere now is that municipals are once again a “spread” product. Protecting a municipal bond from a shift in Treasury rates is not enough, because munis, to use a cliché, have a mind of their own.

In a report that is a must-read if you’re a municipal bond dealer or a statistics geek, Citi analyst Mikhail Foux pointed out that the three-month correlation between the 10-year Treasury yield and the 10-year MMD yield stayed cozily above 75% for much of 2005, 2006, and 2007. Since the financial crisis, the correlation between Treasuries and munis has been at best uneven and at worst negative.

A negative correlation means you’re better off trying to hedge your muni position by playing Keno.

Finding something that moves in the opposite direction of tax-exempt bonds is difficult, Foux wrote, because muni spreads are impacted by idiosyncratic technicals that push tax-free yields around in “peculiar” ways not mirrored by other financial products.

Just imagine how both tax-exempt and taxable municipal bonds would respond if Build America Bonds were renewed, and how indifferent every other financial product in the world would be.

Retail Investors

We’ve postulated that a large component of the volatility and at times outright panic gripping the municipal finance market the past few months has been the uncertainty about who will buy long-term tax-exempt bonds if and when governments need to sell them in any meaningful amount.

Examining the duration tolerances of banks, insurance companies, and money market funds, we have found the preferred habitat on the yield curve for each of them is a lot closer to the front than the back.

Today we’ll look at retail investors, who are the backbone of demand for municipal debt.

The demographic the Federal Reserve describes as “households” owns more than $1 trillion of outstanding municipal securities, or a third of the market. This is not a perfect measure of retail ownership, because the household category is a catch-all that includes things like unions, churches, and hospitals.

Still, the retail buyer is the pillar of the municipal credit market. The reason for this is simple. Because the interest on municipal bonds is ordinarily exempt from taxes, munis have the most appeal to investors who pay the most taxes. And the investors who pay the most taxes are rich people.

The municipal market is more beholden to the whims of rich individuals than to any other type of buyer. So what do rich individuals want? We asked some private wealth managers about what sort of duration tolerance they see from typical clients, and answers tend to range from four to seven years. There are some yield-chasers willing to play at the long end of the curve, but normally the wealthy retail investor isn’t comfortable with the interest rate risk posed by maturities of more than 15 years or so.

“Predominantly, you’re going to be in that intermediate space,” said Anson Clough, managing director of municipal fixed income at Appleton Partners. “When you’re at five-year duration, you’re in a comfortable place for clients’ risk tolerance. When you get beyond six years, you tend to hear more reluctance.”

Clients are primarily concerned with preserving capital and generating predictable tax-free income, Clough said. They’re not necessarily looking to heap on more yield in exchange for interest-rate risk.

“A strong and steady reliable income stream is very important, and eking out another 0.01% isn’t always the primary focus,” he said.

Michael Schroeder, chief investment officer at Wasmer, Schroeder, said his firm benchmarks tax-exempt bond accounts to a Barclays index with an average duration of about 4.5. Most separately managed account managers stay in the 4-to-6-year duration range, he said.

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