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 yearend expiration of the taxable Build America Bond program and the expectation that it will drive tax-exempt supply sharply higher. The bid side for tax-exempts has been clobbered, prompting dealers to pare inventory and sending state and local government debt prices into a tailspin, though yields have strengthened about 10 basis points in two days.
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 this?
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 that's seen nearly daily selloffs and little prospect for relief through yearend, Klein said he 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 selloffs. "I'm not convinced this time it's going to be the case," he said, however. "In munis, you have to look at major watershed events, and this nonextension of BABs is one of those."
The long end of the tax-exempt curve has been bolstered by a number of prosthetic limbs during 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 said, he is unsure how high yields must go before the support point is reached. He said 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 in the market all of last year and most of this year.
Municipal bond mutual funds reported $69 billion of 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.
This flow abruptly reversed in mid-November when funds reported nearly $7.9 billion of outflows in two weeks.
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 did not 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, AAA-rated yield and the 30-year Treasury yield was consistently high, often above 0.8.
This year, the correlation has been generally positive but volatile. The correlation has been negative a few times this year and is currently 0.34.
Without a strong correlation to another asset, the market has yet to develop an effective way for dealers to hedge their municipal portfolios. This worsens illiquidity because dealers do not want to take on bonds if they cannot hedge them.
"It's hard in a fast-moving market for broker-dealers to hedge muni positions," said Alex Roever, an analyst at JPMorgan Chase & Co. "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 SELLOFF
Since Nov. 1 the municipal market has experienced its worst selloff since the beginning of the financial crisis.
November began with the Municipal Market Data 30-year, AAA-rated, general-obligation yield curve rising 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 30 basis points through Friday, to 4.66%.
The weakness was not contained to the long end, either.
Since Nov. 1, 10-year munis have climbed 67 basis points to 3.18%, while 20-year debt is up 92 basis points to 4.4%.
But why? The easy answer is that the impending expiration of the BAB program on Dec. 31 is weighing heavily on market participants.
With sentiment growing in recent weeks that BABs will not 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, a 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 would not necessarily drive tax-exempt yields higher, but a number of issuers bringing BABs to market are not 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 cannot be overstated how much stability BABs had brought to the market in the past 18 months.
In the first two months of the BAB program, the ratio of 30-year, AAA-rated tax-exempts to Treasuries fell from 136% to less than 98%. In the past month, as investors became more convinced that BABs will not be extended, the ratio jumped from 95.6% on Nov. 5 to 105.7% Friday.
That cheapness compared 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 compared to Treasuries in the past six weeks, the Treasury market, too, has sold off considerably during that period, playing a big part in the tax-exempt rout.
Though the correlation between muni and Treasury yields is nowhere near what it was before the crisis, municipals do still seem to respond to big Treasury moves.
Of the 33 market sessions since Nov. 1, 30-year muni and Treasury yields have moved in the same direction 22 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."
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 get too high, issuers would just borrow in the taxable market. This would cut off tax-exempt supply and cap tax-exempt yields.
With BABs gone, however, tax-exempt rates could simply keep rising, he said.
HOW LONG CAN IT 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, … there will be a pretty significant rally," another New York trader said. "When that's going to happen, I don't know, because retail isn't in the game right now. But I expect [it] 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 that 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, he said, and he expects this to persist through yearend.
