The municipal market was mostly unchanged yesterday as a scarcity of supply, unprecedented flows into mutual funds, and minuscule yields on cash continued to bolster state and local government bonds at record-low yields.
Traders said bonds may have been a touch weaker on longer maturities, but were mainly unchanged.
“It’s hanging in,” said a trader in Chicago.
The yield on the 10-year triple-A muni closed yesterday at 2.79%, the same as Monday, according to the Municipal Market Data scale. That is just one basis point higher than the lowest yield since MMD started keeping track in the early 1980s.
The Bond Buyer municipal bond index closed at 113.03, up from 112.84 a day earlier. The index is up 7.8% in the past three months.
Yesterday marked a breather for what has been an almost uninterrupted tear over the past month. In the past 20 trading sessions, the yield on the 10-year triple-A muni going into yesterday had jumped only twice, according to the MMD scale.
The Barclays Capital index tracking yields on high-grade 10-year munis is at its highest level in its more than 10-year history.
The biggest muni exchange-traded fund — iShares Standard & Poor’s National Municipal Bond fund — is up 2.9% in the past month.
The rally has been fueled by a number of factors, most of them contributing to an imbalance: too much cash chasing a dwindling supply of tax-exempt bonds.
Investors have poured $53.59 billion in cash into municipal bond mutual funds this year, according to AMG Data Services. Plus, banks and the renascent leveraged arbitrage fund sector have reportedly stepped up their buying.
Meanwhile, issuance of tax-exempt bonds has tumbled 17.7% this year to $214 billion as of the end of August, according to Thomson Reuters.
The Build America Bonds program has siphoned supply from the tax-exempt market, creating a shortage many traders say is keeping yields depressed.
Issuers have sold $30.5 billion in taxable BABs since the advent of the program in April, according to Thomson Reuters, although there is some debate about whether that sum is replacing tax-exempt issuance or complementing it.
The wall of cash hitting municipal funds coupled with the drainage of supply from the taxable BABs program has left the market starved for paper.
Analysts are increasingly arguing that this rally has become technical rather than fundamental. That is, the strength is now based on market momentum rather than credit concerns, yields relative to benchmark rates, the economy, or the outlook for inflation.
Regardless of fundamentals, the trader in Chicago said the municipal market will probably remain strong until enough supply comes to sate demand.
“Everything just seems to be a shortage of paper right now,” the trader said. “We need to have some supply to dislocate it.”
Two prominent market-watchers — Matt Fabian of Municipal Market Advisors and George Friedlander of Morgan Stanley Smith Barney — distributed reports earlier this week adopting more bearish stances.
Fabian called longer-dated bonds “dramatically overbought,” while Friedlander advised a more cautious approach to municipals.
Both, however, said even if the fundamentals warrant higher yields, the pillars supporting this rally remain in place.
“It is hard to see what would push the muni market off its tracks any time soon,” Friedlander wrote.
MMD analyst Michael Bouscaren in a report yesterday echoed the sentiment that a momentum-driven rally can defy fundamentals indefinitely. He cautioned investors to respect the technical momentum rather than question its validity.
“Analysts agree that credit-quality spread compression in the present time frame has no fundamental underpinning, but instead is primarily driven by a market hunger for yield with little regard for credit risk,” Bouscaren said. “This in no way mitigates the validity of trend, again due to the overwhelming impact of the force of money powering this trend.”
The Treasury market, which has also been on a tear of late, took a hit yesterday.
The 10-year Treasury yield bumped five basis points, while the 30-year jumped six basis points.
The market may have been responding to a retail sales report for August. Retailers posted a 2.7% increase to $351.4 billion, beating economists’ expectations for an advance of 2%.
Joel Naroff, president of Naroff Economic Advisors, said stronger-than-expected retail sales show the economy is recovering, which means the Federal Reserve “will be able to start raising rates sooner than many hoped and long term rates could start rising faster as the days of low inflation look to be behind us.”
Also arguing for higher Treasury rates was the producer price index, which ticked up 1.7%. Economists expected an increase of 1%, according to Thomson Reuters.
“Firms are likely to face continuing increases in costs as the economy moves from recession to expansion,” Naroff said. “Don’t be surprised if inflation starts accelerating with the economic growth.”