A quest for cash in a highly illiquid market and a lack of investor confidence in the tax-exempt bond market in general are among the factors that have sent the yield for The Bond Buyer 40 Bond Index soaring in recent days.
The index jumped a whopping 65 basis points last week and finished with a yield to maturity of 6.74% yesterday.
The yield to maturity for the index rose to 6.54% Friday compared with 5.89% the week before, 5.37% a month ago, and 4.78% a year ago, which follows several years of the index fluctuating in the 4% and 5% range. The average dollar price, meanwhile, dropped to $84.49 Friday from $92.29 the prior week, $100.19 a month ago, and $101.41 a year ago, according to The Bond Buyer.
The index, which is published daily, represents an average of the prices - adjusted to a 6.00% yield basis - of 40 recently issued municipal securities, based on quotations obtained from a handful of municipal securities broker's brokers. The 40 component issues are selected according to defined criteria and are replaced by newer issuers on a periodic basis.
"Many investors were on the sidelines looking for safe haven, and the inability to distinguish risk played a large role in a near freeze in the marketplace last week," said Richard Ciccarone, president and chief executive officer of Merritt Research Services LLC in Oakbrook Terrace, Ill.
A municipal analyst at a New York firm said: "We had a period of extreme illiquidity and we had a situation in which there were margin calls in other products, partly equities, and people needed to sell something and that turned out to be munis."
"People who bought things on margin saw prices move against them and they were forced to raise cash," the analyst said. "We had a huge amount of pricing pressure and the bonds had to cheapen significantly."
Some say that secondary market selling has been exacerbated by both the de minimis tax rule and pricing concerns.
"The de minimis rule requires that 100% of the capital gain on a muni bond is taxed as ordinary income - and not as a capital gain - if that capital gain exceeds 25 basis points per year," wrote Matt Fabian, managing director and senior analyst at Municipal Market Research in Concord, Mass., in his weekly outlook on the municipal market.
"In today's high coupon market, an increasing share of lower coupon bonds - including 5% and higher - are outside of that de minimis range and must sell with a deep discount," he wrote. "This 'popping out' was largely accountable for the steep sell-off last Thursday and Friday."
The highest yield to maturity for the 40-bond index was a 10.44% set on Jan. 2, 1985, according to The Bond Buyer. Meanwhile, the yield to maturity dropped to a low of 4.49% on Jan. 16 of this year.
"Right now, the market is torn in a conundrum as to whether conditions are deflationary given the recession outlook or whether the bailout will prove to be inflationary," Ciccarone said. "Most of the market is leaning toward the strength of the recession, but the other side of that could emerge."
In the meantime, the market is still struggling with the consequences of last week's cheapening - which observers called unprecedented.
"You would be hard-pressed in the history of munis to find a move like that" in The Bond Buyer 40, the New York analyst said. In his opinion, the "worst case scenario" for municipals occurred in 1986 with the proposal to change the taxation of municipals. By comparison, "this market didn't stop altogether - it just got significantly cheaper," he said.
"It's a tough market out there and there's not a whole lot of issuance," said an analyst at a large mutual fund company. "Lots of institutions are freeing up cash - not necessarily to buy municipals but to build cash on the sidelines and be in a stronger position. A lot of them have sold a lot of bonds and we are seeing a significant decline in price."
The rise in the index is further hampering the already sluggish volume and is crimping states' and local governments' financing plans. "Capital plans are being stretched out because the credit market isn't there right now for them to make sense," he said.