Market experts disagree on just what will happen to quality spreads -- the difference between yields on high- and low-grade bonds -- if a prolonged recession continues to undermine weaker credits.
Will investors continue to sacrifice quality for yield, forcing spreads closer? Or, as some suggest, will a flight to quality occur, driving a wedge between yields on gilt-edged bonds and those with a more speculative nature?
R.B. Davison 3d, a vice president at J.P. Morgan Securities, predicted Tuesday that yield spreads between higher- and lower-quality tax-free bonds, already tight at about 100 basis points between triple-A and Baa credits, will not widen dramatically. The quality spread was as wide as 250 basis points in 1981, according to data provided by Delphis Hanover Corp.
"Although quality spreads are narrow by historical standards," Mr. Davidson said, "they are not necessarily too narrow, given the low historical default rates of municipals."
Buyers will hang in as the recession takes its toll on cash-starved municipal issuers and further undermines the already shaky general obligations credits, Mr. Davidson said. Morgan's economists last week darkened their outlook and now see economic rebirth as months away, rather than under way.
Mr. Davidson made his remarks at a conference on municipal bond portfolio performance sponsored by the Institute for International Research, a New York company that runs conferences.
"If the economy follows this scenario, we'll be in a recession probably through the end of spring," Mr. Davidson said. That grim forecast contrasts with the consensus view that a sluggish, modest recovery has already begun.
Nevertheless, the flight to quality will not leave the runway, he predicted. Rather, demand for higher-yielding bonds, coming mainly from institutional investors, will continue to keep quality spreads narrow, according to Mr. Davidson.
"Ninety-five percent of the buyers in our market actually happen to be institutional buyers," Mr. Davidson said. "When they're being put up against indices, they have to reach for a little performance."
In addition, sectors will replace ratings as credit quality gauges. "The market is going to be more worried about certain sectors," Mr. Davidson said. "Picking certain sectors is more important than worrying about what ratings you have."
He noted that health-care, airport, and GO bonds seem headed for trouble, while bonds backed by utility revenues seem insulated from economic troubles.
Another strap keeping yields tight is the abundance of insured paper. Insurance cuts down the number of Baa and A-rated credits and adds to the triple-A pool, although such insured paper now trades at single-A levels in the market, Mr. Davidson said.
George D. Friedlander, a managing director and chief fixed-income strategist at Smith Barney, Harris Upham & Co., also spoke at Tuesday's conference, but presented the view that individual investors still have a role to play as direct buyers.
"Direct retail will rebound again," he predicted.
Quality spreads are too narrow and are bound to widen as the recession spurs a flight to quality, according to Mr. Friedlander. "We have the most severe credit problems that we've seen, certainly since the mid-70s, and yet quality spreads are hovering near their historical lows," he added.
According to Mr. Friedlander's theory, the municipal market has not yet responded to deteriorating credit quality. The delay in response, he said, stems from market inefficiencies.
"When it does respond -- and I believe that it will -- it will respond very powerfully," Mr. Friedlander said.
Mr. Friedlander also said that, despite the current yearend rush to market and this year's new-issue volume approaching $160 billion, a fundamental drought exists in the tax-free market.
"The pent-up demand for munis is absolutely enormous relative to supply," Mr. Friedlander said, predicting municipal bonds will out-perform Treasuries next year.
"Except in periods like right now, when we're seeing a little dislocation just because of the yearend rush to market, there's been a shortage of paper," Mr. Friedlander said.
"I don't think volume is going up next year -- we've used up a lot of the refunding volume that would occur at or near current interest rates. Bond calls are getting greater, supply will not be greater."
In addition, the new year will see the return of large investors who have been sitting on the sidelines amid declining interest rates.
"The larger investors will be back in the market," Mr. Friedlander said. "They're going to have to do something to rebuild their portfolios."
Overall interest rate trends could have narrowed quality spreads, according to Neal H. Attermann, a vice president at Kidder, Peabody & Co.
"Maybe the factor which is driving things is with yields so low, a lot of people are yield hungry and bidding up the price of high-yield paper again," he said.
Also, continued interest rate declines could further tighten quality spreads, according to Mr. Attermann. "If rates continue to go down, and people continue suffering rate shock, we could see the spreads continue to narrow. If rates go back up again, we may see a widening."
