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Turbulent Market Puts Buyers on Guard

The municipal market has become so turbulent and illiquid that even investors who find tax-exempt yields appealing are sitting on their hands.

The recent rout in tax-exempt bonds has some portfolio managers, investors, and dealers beginning to sniff at yield levels that could invite buyers back into the market.

The trouble is the looming year-end expiration of the taxable Build America Bond program and the expectation it will drive tax-exempt supply sharply higher have clobbered the bid side for tax-exempts, prompted dealers to pare inventory, and sent state and local government debt prices into a tailspin.

The municipal market is not accustomed to predictions of widespread government insolvency or being described in Barron's Magazine as "nearly as volatile as the stock market."

Some extra yield is nice, but who wants to buy bonds at a time like that?

Neil Klein, a portfolio manager at Carret Asset Management in New York, said times like these pose a conundrum for money managers: yields are more attractive than they have been in a while, yet it would be imprudent to pour money into a market with more room to fall.

Regardless of yields, his clients would not be happy if the bonds he bought for their accounts immediately suffered paper losses.

"We've seen a significant ramp-up in yields over the last two months creating a quality buying opportunity, but as investment managers we also have to look to the future to see whether there are going to be better opportunities going forward," he said.

In a market with near-daily sell-offs and little prospect for relief through the end of the year, Klein expects to find better deals down the road.

As for the yield that attracts buyers, Klein thinks the market is probably touching on those levels now. He said he is "slowly legging into" the market.

Jed McCarthy, managing member at 1861 Capital Management, said the 5% yield on 30-year tax-free bonds ordinarily is a natural ceiling that contains sell-offs.

As the triple-A 30-year yield approaches 5%, some investors might be looking to the 5-handle as the carrot that lures retail investors out of hiding.

"I'm not convinced this time it's going to be the case," McCarthy said. "In munis you have to look at major watershed events, and this non-extension of BABs is one of those."

The long end of the tax-exempt curve has been bolstered by a number of prosthetic limbs over the past half-decade or so, either from municipalities disguising their long-term debt as short-term securities, leveraged hedge funds absorbing substantial amounts of supply, or the BAB program siphoning tax-exempt bonds into the taxable market.

Without those pillars, McCarthy isn't sure how high yields have to go before the support point will be reached.

He is content to watch this rout from the sidelines for now.

Fund Flow Reversal
The municipal market that so scares people right now is one of heavy supply and uncertainty over the direction of mutual fund investment flows.

Mutual fund flows were a major propellant of the market for all of last year and most of this year.

Municipal bond mutual funds posted $69 billion in inflows in 2009, according to the Investment Company Institute, and in the first 10 months of this year they reported an additional $32.2 billion.

That abruptly reversed in mid-November, when funds reported nearly $7.9 billion of outflows in a two-week stretch.

What had been a continuing source of demand since early 2009 suddenly became a source of supply: mutual fund managers facing redemptions had to sell bonds, pushing paper into a market that really didn't want it.

A market that struggles with sell orders is further plagued by an inability to hedge inventory, which deters dealers from bidding on bonds.

Municipal dealers used to hedge municipal bonds with opposing short positions on Treasury rates because the two asset classes usually moved in tandem.

Before the financial crisis, the rolling 30-day correlation between percentage changes in the Municipal Market Advisors 30-year triple-A yield and the 30-year Treasury yield was consistently high, often above 0.8.

This year, the correlation has been generally positive but unreliable. The correlation has been negative a few times this year, and is currently 0.26.

Without a strong correlation to another asset, the market has yet to develop an effective way for dealers to hedge their municipal portfolios. That exacerbates the illiquidity, because dealers don't want to take on bonds if they can't hedge them.

"It's hard in a fast-moving market for broker-dealers to hedge muni positions," said Alex Roever, an analyst with JPMorgan. "One sure way for dealers to limit risk is to limit the size of their positions. This can curtail market liquidity because it reduces demand for what's in the market. The remaining buyers in the market typically demand higher yields to compensate for the lower liquidity."

Yields Soar In Sell-Off
Since Nov. 1 the municipal market has experienced its worst sell-off since the beginning of the financial crisis.

November began with the Municipal Market Data 30-year triple-A GO yield curve increasing in 10 of the first 11 sessions, four of them double-digit moves. In fact, 30-year yields rose 76 basis points through Nov. 17 alone.

Then, after backing up 26 basis points through Dec. 6, 30-year yields shot up another 49 basis points through Wednesday, to a 21-month high of 4.85%.

The weakness wasn't contained to the long-end, either.

Since Nov. 1, 10-year munis have climbed 76 basis points to an 18-month high of 3.27%, while 20-year debt is up 104 basis points to a 21-month high of 4.52%.

But why? The easy answer is that the impending expiration of the BAB program on Dec. 31 is weighing heavily on market participants.

With the sentiment growing the past few weeks that BABs won't exist in 2011, many issuers have rushed to market to take advantage of the dying program.

"It was definitely a big factor," said Evan Rourke, portfolio manager at Eaton Vance. "It kicked off a supply-demand imbalance during what would have been a light period."

An influx of taxable BAB supply alone wouldn't necessarily drive tax-exempt yields higher, but a number of issuers bringing BABs to market aren't bringing them alone.

"You have a lot of people trying to beat the clock on BABs that also decide to throw in tax-exempt components, so a lot of this is hitting the market all at once," Rourke said. "All while people are closing their books and making sure they have cash on hand for January redemptions."

McCarthy said it can't be overstated how much stability BABs brought to the market over the past 18 months.

In the first two months of the BAB program, the ratio of 30-year, triple-A rated tax-exempts to Treasuries fell from 136% to less than 98%. Over the past month, as investors became more convinced that BABs won't be extended, it jumped from 95.6% on Nov. 5 to 105.7% Wednesday.

That cheapness to Treasuries should in theory bring crossover buyers into the muni market.

"If we got to 110%, that would draw significant buying interest," Rourke said. "But there's a lot of uncertainty out there with the end of the year approaching, and relative value is only important if absolute value holds in."

Despite the fact that munis have significantly cheapened to Treasuries over the past six weeks, the Treasury market has sold off considerably during that period as well, which played a big part in the tax-exempt rout.

While the correlation between muni and Treasury yields is nowhere near what it was pre-crisis, municipals do still seem to respond to big Treasury moves.

Of the 31 market sessions since Nov. 1, 30-year muni and Treasury yields have moved in the same direction 20 times. More than half of those came during sessions where Treasuries moved five or more basis points.

"It's true that we're really not correlated with Treasuries anymore and that you can't really peg where munis are going based on the Treasury, but we do still pay attention," a New York trader said. "When there's a significant move in Treasuries, it usually has an impact."

Since Nov. 1, 30-year Treasury yields have increased 58 basis points to 4.59%, slightly more than half the 99 basis points triple-A 30-year munis have climbed over the same period. However, 10-year Treasuries have climbed 89 basis points to 3.52% since Nov. 1, more than the 76 basis point increase seen in comparable munis since then.

Rourke noted that such a move for the benchmark Treasury yield was bound to cause a significant pickup in interest rates.

"Munis are not going to be immune to that," he said.

While muni yields have risen throughout the scale, the very short end has shown just nominal losses since Nov. 1. However, from five years on out, triple-A yields have increased at least 40 basis points in that timeframe.

And the curve has steepened dramatically, too.

On Nov. 1, the spread between five-year and 30-year triple-A GO yields was 266 basis points. Since then, it widened 57 basis points to 323 Tuesday, the widest that spread has been in 10 years, according to MMD.

That spread widening can be partly attributed to the pricing in of an anticipated significant uptick in long-term tax-exempt issuance in 2011.

"The lesson of the last month was that the market was not set up to absorb the expected supply in 2011 on the long end at the current rates," McCarthy said.

When BABs are an option for issuers, the market has a natural ceiling because if tax-exempt rates got too high, issuers would just borrow in the taxable market. That would cut off tax-exempt supply and cap tax-exempt yields.

With BABs gone, however, he said tax-exempt rates could simply keep rising.

How Long Can This Last?
Many municipal market participants look to early next year, when supply will almost certainly ease back.

"I think what will happen is retail is going to keep their eye on it, and when we get to a point where retail gets excited about it, maybe a 5.20%, there will be a pretty significant rally," another trader in New York said. "When that's going to happen, I don't know, because retail isn't in the game right now. But I expect to firm up pretty early in the new year."

Ron Schwartz, who manages the $1.22 billion RidgeWorth Investments Investment Grade Tax Exempt Bond Fund, said at some point tax-free yields will jump high enough to appeal to crossover buyers like hedge funds and insurance companies.

For now, though, part of the reason long-term municipals are cheap is illiquidity, Schwartz said, and he expects that illiquidity to persist for the rest of 2010.

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