Munis Weaker in a Market That's 'Everywhere'

20080925ratz4qqm-1-market-news-e.jpg

The municipal market was weaker yesterday as participants reported widening bid-ask spreads in the secondary, a focus on pre-refunded paper, and a much curtailed new-issue calendar.

Traders said tax-exempt yields were higher by three to five basis points.

"The market is everywhere. It's a workout market," a trader in Chicago said. "Some trades look way too high, others look way too low. Retail seems to be buying in, driving the market a bit, and the short end is doing alright, although it's probably a bit easier outside of 10 years."

"It doesn't make any sense. You can buy [pre-refunded bonds] 20 to 30 basis points cheaper than you can buy Treasuries," the trader added. "At some point, that's got to turn around."

The Treasury market showed losses yesterday. The yield on the benchmark 10-year note, which opened at 3.81%, finished at 3.87%. The yield on the two-year note finished at 2.15% after opening at 1.99%. The yield on the 30-year Treasury finished at 4.41% after opening at the same level.

The Treasury market continued to trade on financial news events, disregarding weaker economic data. The news that Congress had struck a preliminary agreement for a $700 billion bailout plan helped buoy the stock market Wednesday and sent people out of the flight-to-quality Treasury bid, according to Howard Simons, a strategist at Bianco Research.

"We're cancelling part of the insurance trade; we've been buying Treasuries for crash insurance," Simons said. "We are reallocating from heavily overbought Treasuries."

In the long term, Simons said, "it's very hard to argue we're going to see significantly lower yields even if the economy weakens."

The price tag of the bailout, along with rising costs of entitlement spending for the aging baby boomer generation, will hurt the quality of government debt, he said.

"That's going to be something that's going to color our economics and color our politics for a very long time," Simons said.

The news of the bailout plan yesterday follows last week's news of Lehman Brothers' bankruptcy and its fallout, in addition to the government rescue of Fannie Mae, Freddie Mac, and American International Group Inc.

In the wake of these unprecedented developments, the new-issue market has mostly ground to a halt, with a slew of issuers either postponing, cancelling, or dramatically reducing in size their pending transactions.

Yesterday, at least one more deal was postponed, as a scheduled $45 million competitive transaction for York County, S.C., did not price as scheduled.

However, despite the muted activity in the new-issue market, the secondary market has not seen trading volume tail off, either in number or size, nearly as substantially.

The secondary market is "pretty much where all the action is," said George Strickland, managing director and portfolio manager at Thornburg Investment Management.

"Most of it is [pre-refunded bonds] right now. There are a lot of [them] trading, and there are some other bonds trading," he said. "Mostly all the sellers are [arbitrage accounts], and maybe throw in the high-yield funds as well. They seem to be getting redemptions and hitting some bids, but most of the activity is arbs. It seems like you buy $5 million, and then there's $5 million more, and then there's $5 million more, and it keeps going on. It's not the kind of environment that makes you feel real good about stepping up and paying a fair price."

Strickland also said that there has been a noticeable widening of the spread between bid and ask.

"I've seen people unabashedly making markets in bonds where the difference between bid and ask is 50 basis points," he said. "Not too long ago, they were ashamed to show a five basis point mark. It's a brave new world."

He said this is the case in large part because the market is filled with "reluctant sellers and reluctant buyers."

"I've got this bond I want to sell, I want to get somewhere close to my eval, and so someone makes an offering on it, and then the bid side happens to be 50 basis points away," he said. "You're at that kind of market. It's not a very liquid market. And everything that you buy, you look at it a day later and say, 'I wish I hadn't done that.' "

With the market suffering from illiquidity, smaller sales blocks are currently more attractive than big ones, according to Dick Berry, a senior portfolio manager at Invesco AIM.

"Right now, if you're selling in size, it's to your disadvantage," he said. "It used to be to the seller's advantage, but the brokers just don't know how fast they can retail the bonds out, so they're not buying anything in size."

However, despite this, Strickland said "you can't argue with the fundamental value" of munis "for a long-term player."

"It's very hard to pick absolute bottom. But if you've got cash to spend, you see value, and you discount from there and show a number," Strickland said. "You know you might get that queasy feeling the next day when you see the bonds a little cheaper, but ultimately it's going to pay off in the long run."

He added that he's seen a pickup in retail interest in bonds, but "outside of that, there's not a lot of support for the market."

"I'm not seeing many signs of insurance companies coming in and buying a bunch of bonds, and they can be a big source of demand," he said. "Certainly all the leveraged guys are getting crushed, so the last thing they want to do is buy more bonds. It is a good environment. It's a value-based environment, a very good environment for an unleveraged, conservative type manager like us, but it still doesn't make it any easier when you buy bonds."

For reprint and licensing requests for this article, click here.
MORE FROM BOND BUYER