The giant question mark of whether bankers will be able to find buyers for municipal bonds if and when they come in heartier supply continues to keep dealers sidelined, demand sickly and yields drifting up.
Municipals delivered a total return of negative 0.6% in the second half of March, according to a $1.3 trillion Standard & Poor's index.
The poor performance comes during a major supply drought. Municipalities sold just $2.4 billion of bonds last week to close out the lowest quarterly issuance in 10 years. They are slated to sell $3.3 billion this week. The market is having trouble placing even this small amount of debt.
It is unclear how much demand there is for tax-free municipal bonds. Until the market finds out, buyers see no need to reach and sellers see no need to concede.
"So many reasons just to sit on the sideline and do nothing," said a trader in California. "The buyers and most of the sellers see it the same way."
This trader expects "a much different market" in a month and a half, when supply finally picks up.
"Traders are going to be hurting," he said.
The stasis that is keeping yields from adjusting higher for now was thoroughly outlined in a report on Friday by Michael Zezas, who heads municipal research at Morgan Stanley. In short, he said, demand is weak. Investors think yields are too low and don't want to buy at these levels.
Normally, that would force sellers to cut prices to entice buyers. But with so few bonds coming to market, dealers have no impetus to slash their asking prices.
The combination of low demand, low supply and dealers' reluctance to offer concessions leaves the market in a weird stalemate. What remains is "a market with no conviction in current valuations, but with little incentive to sell bonds," Zezas wrote.
What can jolt the market out of its stalemate?
Municipalities will not stay out of the market forever. The national economy is growing; state and local governments need to replace equipment and finance projects.
While Zezas slashed his forecast for municipal borrowing in 2011 to $270 billion from $375 billion, he still thinks muni issuance will grow by more than a third in the second quarter from the first quarter.
The increase in issuance will "almost certainly" force rates up to tempt enough buyers, according to Zezas.
His conclusion? Avoid long duration for now. The tax-exempt yield curve will probably have to steepen to clear new-issue volume, he said.
Zezas does concede he could be wrong; if retail investors turn out to exhibit more appetite for tax-free bonds than expected, demand could meet a greater amount of supply.
But he doesn't think that's the case. The retail investor not only had a great deal of difficulty absorbing last year's tax-exempt supply, which was only about $275 billion — he even had some trouble absorbing this year's anemic first-quarter supply.
When yields in the first quarter reached extraordinarily high levels, some retail interest was said to appear, but mostly it was life insurance companies and hedge funds.
It's unclear that retail investors are ready for more tax-exempt supply, given a lack of such interest in January, when the 30-year triple-A muni yield exceeded 112% of the 30-year Treasury yield.
