The municipal market has always had a buyer of last resort. This category of buyer had the capital and the leverage capability to buy municipal bonds when they were attractively priced relative to Treasuries or other appropriate benchmarks. In the absence of the buyer of last resort, the market was vulnerable to getting progressively cheaper relative to other fixed-income markets due to imbalances in supply and demand. From the inception of the market, this important role was filled by the nation's commercial banks.
During the 1970s and the 1980s, bank activity dominated the municipal landscape as banks were profitable, growing rapidly, and interest rates on bonds were rising. Along with banks, the buyer community consisted of unit investment trusts, trust departments, and insurance companies.
UITs were huge buyers of municipals in the 1970s with trusts exceeding $50 million. The first municipal bond mutual fund started operation in 1976. The individual investor began their direct involvement in the market with the advent of bond insurance. Ambac began to insure municipal issues in the early 1970s. During this time, investment managers became a feature of the buyer community.
In 1986, however, Congress passed legislation that limited banks' ability to buy municipals and write off the interest expense incurred. While the law exempted small bank-qualified bond issues, the change eliminated the only buyer in the market that had the capacity to borrow and invest opportunistically when bonds were cheap. During this time, mutual funds replaced UITs as the consumer product of choice. Insurance companies continued to be a staple of the buy side, although their purchasing tended to be cyclical based upon the profit cycle of the industry.
Shortly afterwards, the large dealers initiated the arbitrage account. Arbitrage accounts bought municipals using the firm's capital to generate trading profits. Generally, the arbs hedged their positions with Treasury futures. First Boston and a number of other firms were among the first firms to manage arbitrage accounts. They would purchase municipals, hedge them, and reverse the position when municipals outperformed.
The advent of the arbitrage account increased the market's focus on inter-market relationships. By creating arbitrage accounts, the Street had manufactured a solution to the loss of the commercial banks as buyers of last resort.
In the 1990s, the influence of mutual funds continued to grow. Insurance companies remained active despite tax legislation that "haircut" the tax-exempt income of municipal bonds held by insurance companies. UITs began to decline in influence. Trust departments struggled to maintain market share, and many trusts began to open their own series of mutual funds.
Until recently, the landscape has increasingly been dominated by a variety of proprietary accounts. In addition to arbitrage accounts, tender-option bond programs were established to generate profits through yield curve arbitrage.
Many of these activities were exported from the dealer community to hedge funds, investment managers, and other buyers. Mutual funds began to purchase inverse floaters in their portfolios, effectively running their own TOB programs from a mutual fund. Hedge funds sprouted up, using a variety of municipal trading strategies that generally involved hedging and leverage. The key component that they had in common was the ability to buy municipals opportunistically with the benefit of leverage.
During the 1990s, new issues were increasingly subscribed via the activities of arbitrage accounts, hedge funds, and TOB programs, and less from the "traditional" buyers - mutual funds, trust departments, and insurance companies. This created friction among the buyers, who felt that because of their willingness to hold bonds for long periods of time, they should be accorded better treatment on new issues than "flippers."
In 2007, the "non-traditional" buyer - arbitrage accounts, hedge funds, tender-option bond programs, and other levered strategies - reached their zenith. It had become impossible to subscribe a larger deal without their participation.
The reason these buyers had become so critical to the municipal market was that other long-standing supporters of the market - banks, mutual funds, UITs, and trust departments - had either been forced out of the market through tax changes (banks), succumbed to the fate of being a mature industry (mutual funds), or had fallen into declining secular importance (UITs and trust departments) due to changing investor preferences. Insurance companies continued to be an important buyer in the market, but roughly in equal proportion to their importance in previous years.
Today, the short-term municipal market continues to be in a state of disruption caused by wounded bond insurers, ailing banks, and risk-averse buyers. Consequently, current reduction in leveraged purchasing of municipal bonds in all its forms - TOBs, arbitrage accounts, hedge funds, etc. - has put severe limits on the only source of well-capitalized purchasing of municipals available to the market.
The risk to the market is incalculable. There is no category of investor currently available to step in on any given day with fresh capital to purchase municipals and provide needed buying support when supply exceeds demand. One consequence is that the ranges of the ratio of municipal to taxable yields will be much wider going forward than what has prevailed over a decade or so. In addition, municipals are at risk to get cheaper, and stay cheaper.
One solution is to return to the previous regimen before 1986. While banks are not likely to be major purchasers of municipals, they could eventually return to filling the vital role of buyer of last resort. A solution being considered in Washington is to liberalize the definition of a bank-qualified bond so that banks can increase their participation in the marketplace.
We expect that this important buyer of last resort function will eventually be resolved. It may be that banks and broker-dealers will increase the capital that they allot to the municipal business in a year or two, and that arbitrage accounts, TOB programs, and hedge funds experience a renaissance. For the moment, however, there is the risk that the pricing equilibrium will rely on a "one-legged stool" of buyer support - the retail customer.
Chris Mier is a managing director at Loop Capital Markets and runs its analytical services group.