Low interest rates have significantly colored the outlook industry veterans have for the municipal market.

The current muni market, which has the 10-year around 2.29%, should expect to see high muni ratios to Treasuries and corporates, as well as more current refundings for the next year, according to panelists at the fourth Bloomberg State and Municipal Finance Conference in New York.

In addition, they added, Capitol Hill will be pressured around 2013 to take a more serious stab at debt reduction, and thereby likely place the tax exemption for some part of the muni market more seriously at risk.

Panelists addressed high muni ratios to Treasuries and corporates. With rates as low as they are, and retail thus sidelined, the attractive ratios have been necessary for luring the latest group of institutional buyers to help price performance: crossover buyers, said Peter Hayes, head of municipal bonds group at BlackRock.

“What the market has done essentially is repriced itself to attract the crossover buyer,” he said. “So now retail isn’t just competing with mutual funds, they’re competing with hedge funds, pension funds, insurance companies, and others who don’t need the tax exemption. I think that’s helped the volatility; we haven’t seen nearly the volatility that other asset classes have, [such as] equities, even Treasuries. … We need to stay in this environment in order to attract that crossover buyer on an ongoing basis.”

Also, it’s important to look at muni ratios to corporate bonds rather than just Treasuries, added George Friedlander, senior municipal strategist at Citi. And there, munis are almost on par, he said.

The Federal Reserve’s efforts to artificially reduce Treasury yields, such as through quantitative easings and Operation Twist, have left munis in a bind. Muni yields cannot follow those of Treasuries, Friedlander said, particularly when the primary market is seeing around $8 billion in new issuance a week and retail investors have been daunted by rate shock.

But if ratios were a notable topic of conversation, so was the prospect of munis losing their tax-exempt status. And while the federal government is unlikely to make that a reality this year, he said, it’s a distinct possibility in 2013. By then, the pressure to reduce debt at all levels of government will be severe, he added.

Republicans, for one, view subsidized issuance as encouraging more debt, which is anathema to them, Friedlander said. And the Democrats see munis’ tax-exemption as a subsidy for the wealthy.

“We don’t have enough friends on either side of the aisle,” Friedlander said. “Look at where muni ratios are. How do you make the case that we need the tax exemption?”

Furthermore, if it does disappear, the calls for increased disclosure that are spreading across the financial markets will grow louder for municipals, said Kathleen M. Evers, head of municipal credit analytics for BMO Capital Markets. Munis have had a nice situation for some time — they don’t necessarily need to provide a quarterly operating statement to the market, as corporations must.

Munis will be competing with corporate bond disclosure, she added, and their requirements in the market for those issuers will affect state and local governments.

“The threat is pretty real,” Evers said. “When we look at the possibility of tax exemption going away, and what it means for the buyer base, which to a large extent has already diversified into other buyers that traditionally bought taxable debt, the disclosure issues are going to become more important in our market.”

Panelists also discussed how the muni market is in for another year or so of current refundings from issuers. For October, pure new issuance represented half of all new product in the primary, refundings about one-third, and a combination made up the balance, Friedlander said. “And most of those refundings were current refundings,” he added.

The muni market is in a cycle of current refundings that should continue to increase next year, Friedlander said. This is because the market is at the 10-year anniversary of an increase in supply from 2002, versus 2001, and another increase of supply in 2003 versus 2002. And typically, current refundings hit at the nine-and-a-half-to-10-year anniversary mark, especially if yields are lower, Friedlander said.

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