A couple of top-quality deals on Wednesday offered little clarity on the market’s strength, depth or direction.
After wallowing through nine weeks of minimal supply, the public finance industry is still defined mainly by its lack of activity. The Municipal Market Data scale has showed 10-year yields at 3% all week, but market participants say there aren’t enough bonds changing hands to really validate a firm price.
Maryland and the Georgia State Road and Tollway Authority each priced sizable deals on Wednesday, more or less in line with the triple-A MMD scale.
While it may have been encouraging to see these deals digested without a hiccup, the investors we’ve spoken to don’t think the successful absorption of a couple of triple-A rated offerings communicates much about the conditions rumbling beneath a very thin surface.
It remains to be seen how the Street would handle a weekly supply of much more than this week’s $3.5 billion, let alone a substantial amount of lower-grade paper.
“There’s a lot of people still holding out to see what the supply picture’s going to look like,” said Adam Mackey, managing director of municipal fixed income at PNC Capital Advisors. “I sense there is resistance to the rate level right now. Give us any deals that are sizable, that are mid-to-low grade, and I think we fade. We’re not going to stay this thin for the entire year.”
The Georgia tollway authority borrowed $359.4 million in the competitive market, with Citi the winning bidder. The 10-year maturity priced at 3.02%, a couple of basis points above the MMD triple-A scale.
Maryland found buyers for $485 million of its bonds, with $354.2 million pricing today in the competitive market. Bank of America Merrill Lynch was the winning bidder. The 10-year maturity of that deal was reoffered to the public at 3.1%, or 10 basis points above the triple-A scale.
Maryland Treasurer Nancy Kopp put out a statement saying demand for the state’s debt was “great.”
The question is whether demand is great because of fundamentals, or because any liquidity that finds its way into the market has nowhere else to go but to the few deals that happen to be pricing.
Joseph Darcy, head of public finance at Hartford Investment Management, said earlier this week he put out a bid he considered fair on some bonds in the secondary market, only to be significantly outbid.
“The only conclusion that I could draw was that there were commitments being made driven by the perceived scarcity value,” Darcy said.
He expects “periods of indigestion that are induced by bursts of supply” later in the year.
Mackey doesn’t infer much of a meaningful conclusion from the deals that priced Wednesday. Pricing $700 million of absolute-highest-grade municipal paper is all well and good, but these are favored credits hitting the Street during a supply drought. More disconcerting is the question of how lower-grade deals price if supply ever picks up. And supply will pick up, Mackey believes.
In explaining why, he accidentally wrote a poem: “Budget decisions are going to get made/Infrastructure is going to get laid/and bankers are going to get paid.”
Yesterday we talked about municipalities’ difficulty raising proceeds for long-term projects because each major component of the buy side hates long-duration tax-free bonds for its own reasons. We highlighted property and casualty insurers, whose average duration preference of 4 keeps them anchored away from the longest portion of the curve, where duration can easily exceed 10.
Today we’ll examine life insurers, who with $5 trillion in financial assets are a potent force in credit markets but not a particularly robust source of demand for munis. Life insurers own less than 3% of the outstanding municipal supply, and we could not locate a single mention of the industry in the 1,300-page Handbook of Municipal Bonds.
The life insurance business model is similar in many ways to the property-casualty model: they collect premiums in exchange for promising future payouts that are triggered by a certain event.
In both cases, insurers expect eventually to spend basically every dollar they collect in premiums administering claims. They earn money by investing the premiums before they are paid out.
The challenge is to construct a portfolio whose duration matches the duration of the expected claims payments — that way the investment portfolio throws off as much income as it can for as long as it can before funding the claim.
The difference between the two types of carriers is that the event that triggers payouts from life insurers is death. Life insurers actually take both sides of the death gamble: they sell life insurance, where they pay money once someone dies; and they also sell annuities, where they keep paying someone money until he or she dies.
A defining distinction for life insurance is that the anticipated payout is a longer-duration liability. A lot of the products life insurance companies sell by nature are sensitive to changes in interest rates. Imagine an insurer paying an annuitant $10,000 a year every year in perpetuity. If interest rates go down, the present value of those annual payments will increase — the very definition of duration.
The relatively high duration of their liabilities means life insurers like to buy long-duration bonds for their investment portfolios to immunize their liabilities. The average duration in a life insurance companies’ fixed-income portfolio is 6.9, according to SNL Financial.
CNO Financial Group, for instance, has an average portfolio duration of 8.8, and Torchmark Corp.’s portfolio has a duration of 9. This duration tolerance places life insurance companies more toward the long end of the yield curve, which is where municipalities are currently struggling to find buyers.
To underscore where a duration tolerance of 6.9 falls in the municipal maturity spectrum, Vanguard’s $6.9 billion long-term tax-free mutual fund has an average duration of 7.4, and USAA’s $2.2 billion long-term muni bond fund has a duration of 9.2.
There’s just one problem: life insurance companies usually don’t pay a high enough tax rate to warrant buying tax-free bonds of any duration. A life insurer basically runs two portfolios: one to fund future liabilities, and one to earn an aggressive return on its own surplus. Only the surplus investment income is taxed. The portfolio of investments dedicated to funding insurance claims is exempt from taxes.
Life insurance companies, therefore, usually have low enough overall tax rates to disrupt the calculus for buying tax-free bonds. Insurers’ after-tax return on taxable bonds is generally higher than tax-free yields.
Life insurers were among the “crossover” buyers who reportedly bought long-term tax-free munis earlier this year when ratios to Treasuries reached swollen levels, but the tax math only makes sense when municipal rates are abnormally high.
So property-casualty insurers pay a high enough tax rate to merit buying tax-exempt bonds, but don’t have the duration tolerance for long-term maturities. Life insurers have the duration tolerance for long-term maturities, but don’t pay a high enough tax rate to merit buying tax-exempt bonds.
That’s why life insurers own just $76.7 billion of municipal bonds — 1.5% of their assets.