The municipal bond market since 2007 has seen a steady drop in the stock of outstanding prerefunded bonds, which are the highest-credit-quality municipal security in existence.
This year alone, the prerefunded market has shrunk by $22 billion, based on a method Municipal Market Advisors’ Matt Fabian uses to estimate the size of the market according to the outstanding Treasury bonds used to support them.
At the apex in June 2007, state and local governments had nearly $347 billion of outstanding prerefunded bonds based on this measure, or about 13% of muni securities. That supply is down to $224 billion, or less than 8% of the $2.8 trillion in outstanding municipals.
In a report on Friday, Bank of America Merrill Lynch analyst John Hallacy estimated nearly 43% of existing prerefunded bonds are scheduled to mature by the end of 2012. Almost three-quarters of the market will have expired by the end of 2013.
The size of the overall municipal securities market shrank in the second quarter for the first time in nearly a decade, according to the Federal Reserve, which market watchers mainly attributed to the roll-off of prerefunded bonds without new replacements.
Coupled with the demise of the bond insurance industry, this has forced a major contraction in the availability of triple-A rated bonds.
The shrinkage of this market stems from a phenomenon known as negative arbitrage.
Municipalities often refinance debt before it is eligible to be redeemed. This can be accomplished through an advance refunding, in which the municipality sells new bonds and uses the proceeds to buy Treasury bonds that mature at the same time the issuer’s existing debt becomes callable. It places those Treasury bonds in escrow, uses the cash flows from the Treasury to service its debt, and then uses the principal at maturity to call the bonds.
Because the repayment on the municipalities’ bonds is supported by a Treasury bond, prerefunded bonds have essentially the same credit risk as federal government debt: zero.
Not all tax-exempt bonds are eligible for advance refunding and the tax code limits those that are to one advance refunding per new money bond issue.
An advance refunding only makes sense if the cash flows generated by a Treasury bond are sufficient to repay the issuer’s own bonds. If Treasury yields are much lower than the yields on the municipality’s debt, the difference would erode the savings from the deal. The municipality would have to pay out of its own resources the gap between the Treasury yield and its own debt-service costs.
With municipal yields elevated relative to Treasury yields, the negative arbitrage scenario makes advanced refundings uneconomical for many municipalities.
George Friedlander, municipal strategist at Citigroup, likes to look at 20-year double-A rated municipal yields versus five-year Treasury yields as a proxy for negative arbitrage conditions generally. On this basis, this is just about the worst time for advance refundings in history, with the exception of late 2008.
The 20-year double-A muni bond yields 3.69%, according to Municipal Market Data, while the five-year Treasury yields 1.23%. That means it would cost a high-grade municipality with 20-year debt that becomes callable in five years about 245 basis points to advanced refund the debt. Five years ago, the 20-year double-A yield and the five-year Treasury yield were just about even.