The municipal bond market was slightly firmer yesterday in a session largely free of economic data.
“The market is firm, and munis are cheap to Treasuries,” a trader in Chicago said. “It’s tough for people to accept these levels, but it’s the January effect. We are seeing people that have rollover and they have to pay whatever it takes. We’re firmer by one or two.”
Thirty-year, triple-A rated munis now yield 96.3% to 30-year Treasury bonds, according to Municipal Market Data. Over the past year, that ratio averages 89.2%. Against this backdrop, trading desks returned to full strength yesterday for the first time since the holidays began. And with supply already stretched thin, market players are bidding up prices.
“The market is very aggressively bid,” a trader in New York said. “We need to get a couple of deals priced and that will help us going forward. We’ll get leadership from the large Washington state deal and some of the smaller deals this week. I’d say the market would have to be tighter this week, as more players jump into an already tight market.”
The Treasury market yesterday was mixed. The yield on the benchmark 10-year Treasury note, which opened at 3.87%, closed at 3.84%. The yield on the two-year note was quoted near the end of the session at 2.76%, after opening at 2.74%.
In the wake of all the news about bond insurers, and the holiday season, many questions still persist among market observers about what this year will bring. Many people are examining the current market conditions, trying to predict the levels of institutional and retail demand.
“Ordinarily we enter January, after a period of illiquidity over the holidays, needing to find the levels where bonds will clear the market,” Phillip Fischer, municipal strategist at Merrill Lynch & Co., wrote in a recent report. “This price discovery is exacerbated this year because the severe credit crunch has led to negative returns at high yield mutual funds, hedge funds, and dealer desks across the market.”
“As a result, we need to identify the market structure — how much investors are willing to commit in new capital — as well as the pricing levels of the securities,” Fischer added. “The good news is that market activity was stronger than expected in the first week of the year.”
Fischer wrote that, overall, investors have been selling high-yield bonds and picking up highly rated credits, while hedge funds have shown little activity in recent weeks. George Friedlander, fixed-income strategist and managing director at Citi, also wrote in a recent report that institutional demand in 2008 may be spotty.
“Tender-option bond programs have been in the market, but it will take time to see what their appetite looks like in the new year,” Friedlander wrote. “Casualty companies will continue to be moderate net buyers, we suspect. That leaves direct retail, which has the capacity to absorb a considerable amount of paper.”
However, retail buyers are still reluctant in some respects to enter the market at the current yield levels. Thirty-year, high-grade munis yielded 4.20% yesterday, according to MMD, far lower than many retail investors would like. However, Friedlander believes that the Federal Open Market Committee will make future cuts to the federal funds target rate, and that those cuts will bolster demand.
“If the Fed continues to ease, as we believe it will, the resulting steeper slope to the yield curve should help increase the appetite for munis,” Friedlander wrote. “The bottom line is that the muni market will have to absorb a considerable calendar of new issues, probably with less help from the bond funds.”
The market should also be helped by a slowing economy.
“A slowing economy and an easing Fed are powerful buy signals for fixed-income securities,” Fischer wrote. “With muni yields already hovering around Treasury levels, the flight to quality in Treasuries should propel muni returns more this year than last. In fact, the muni market is relatively well set up for an economic slow down. Ratios to treasuries are high and credit spreads wide.”
Friedlander believes the widening credit spreads are related to a repricing of risk in the muni market. It is this risk, in part, that is keeping institutional investors on the sidelines.
“In our view, this widening of credit spreads partly reflects a fundamental repricing of risk in the fixed-income markets generally, rather than a substantially weaker credit outlook for munis,” Friedlander wrote. “As market participants have become more concerned about the bond insurers, and the value attributed to insurance has declined, credit spreads on uninsured bonds have moved wider as well.”
Meanwhile, the economic calendar is inactive yesterday. Later this week, potentially market-moving data will be released. On Thursday, initial jobless claims for the week ended Jan. 5 and continuing jobless claims for the week ended Dec. 29 will be announced. Also Thursday, November wholesale inventory and November wholesale sales will be released.
Economists polled by IFR Markets are predicting 340,000 initial claims, 2.75 million continuing claims, gains in wholesale inventory of 0.3%, and 0.3% growth in wholesale sales.
The new-issue calendar was light yesterday.