Record Treasury Debt Seen to Have Minimal Short-Term Effect on Munis

The record amount of Treasury debt issued last week will have a minimal short-term effect on municipal bond yields, as inflation and interest rates are expected to remain low at least through the end of the year, market participants said last week.

Muni yields would likely rise with Treasury yields if the government is forced to increase interest rates to attract buyers, they said. However, last week demand for the $235 billion of bills and notes auctioned remained adequate, especially from foreign buyers, according to sources. Meanwhile, demand for munis remains strong as individual investors buy high-grade credits and pour cash into tax-exempt mutual funds.

Treasury market gyrations "have not really affected the municipal market," said Dominick Mondi, senior managing director of municipal trading at Mesirow Financial Inc. in Chicago. Though munis have detached from trading in lockstep with Treasuries, the tax-exempt market is "keeping an eye on [Treasuries] for any dramatic move," he said.

The market will have to absorb more government during the next three months. The Treasury is expected to issue $446.0 billion of bills, notes and bonds in the third quarter compared with $343.0 billion in the second quarter, according to a survey of securities firms that was conducted by Securities and Financial Markets Association and released Thursday. The survey respondents estimated the 10-year Treasury yield will be 3.70% in September and 3.90% by the end of the year.

A 10-year Treasury yielded 3.53% Friday afternoon and a triple-A, 10-year muni bond yielded 3.01%, according to Municipal Market Data.

"Our concern is, what yield will [Treasury] have to offer to attract foreign investors?" said Peter Hayes, who leads BlackRock Inc.'s municipal team. If Treasury demand weakens and rates continue to rise this year, "muni rates will be affected to some degree albeit not to the degree that we think Treasuries will be affected," he said.

Sources said the debt issuance is not likely to spur inflation concerns in 2009 and that the Fed will not have to raise interest rates this year.

"The Fed has been very vocal about keeping the funds rate anchored close to zero," said Michael Pietronico, CEO of Miller Tabak Asset Management.

Economic factors may benefit munis as the recession shows signs of easing. Retail investors would like to see interest rates moving higher because "that would be a signal that municipalities are going to see higher tax receipts," Pietronico said.

Munis "will perform quite well in the initial stages of an economic rebound," particularly the first three to four months, as concerns about defaults and downgrades ease, he said, adding that the economy "is scraping at the edges" of that recovery now.

If Congress has to raise taxes to help pay off the government debt, munis will benefit, sources said. Already, many legislatures have raised local taxes to fill their budget gaps.

"The federal government is greatly increasing its costs, so in theory it should be good for tax exempt bonds," said Matt Fabian, managing director of Municipal Market Advisors in Concord, Mass.

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