Market Outlook
As equity markets around the globe swooned, the bond market has finally caught a bid, if only for the time being. Apparently, even far-flung emerging markets have indirectly benefited from the Federal Reserve’s liquidity injections and they are now paying the piper, as evidenced by their faltering currencies.
Central to the current global turmoil is the realization that the U.S. economy is, in fact, outperforming the rest of the world. Admittedly, this is not a very high bar to meet, given the disastrous state of the European Union and the recent slowdown in China’s growth engine. Nonetheless, our economic recovery seems to be steadily taking hold, driven this time around by an unexpected domestic energy boom. According to the Wall Street Journal, “the U.S. last year posted the biggest increase in oil production in the world and the largest increase in U.S. history.” Between the shale natural gas boom and improving energy efficiency, there is no doubt we are making great progress toward energy self-sufficiency and laying the foundation for hopefully longer-lasting growth.
As traders looks ahead to next week’s Fed meeting, the rising volatility in global equity and currency markets should help keep further Treasury yield increases in check.
While any stabilization in Treasuries can only be helpful, the $3.7 trillion municipal market is struggling with its own issues. As reported by The Bond Buyer, “in the most recent selloff, muni yields have soared. From May 1, the 10-year yield has jumped 61 basis points from 1.66% to 2.27% Thursday. The 30-year yield jumped 73 basis points from 2.79% on May 1 to 3.52% Thursday.” Bloomberg also points out that 10-year muni yields are now the highest since March 2012.
Many of the street traders were stunned by the magnitude and speed of this recent correction. One even compared this to 1998’s market meltdown. Of course, no one expected the last two years’ rally to last forever, but the yield spike, when it did come, still caused a big shock, largely because it occurred during a period of strong technical factors. With large reinvestment flows expected for June and July, investors got a bit too complacent (which we warned about in an earlier column) and got caught with their pants down.
On the high yield side, the performance of the recent Iowa Fertilizer issue (which we discussed in a previous column) is indicative of how far we’ve come in just six weeks. The 5 ¼% due 12/1/25 bonds came to market at the beginning of May at 99.50 and traded as high as 104.50 the following week. Yesterday they traded at 97.75, down 6 ¾ points from the high and 1 ½ point below the initial price.
One of the reasons we decided to publish this column on Fridays is to incorporate the mutual fund flows reports, normally released on Thursdays. Unfortunately, the news continues to be grim this week. On the heels of last week’s massive outflows of $1.5 billion, investors redeemed another $1.6 billion for the week ending June 12th, according to Lipper. Not to be outdone, Bill Gross at Pimco is also rumored to be reducing his stake in municipals.
Market illiquidity can also be compounded by a lack of transparency.
The general decline in liquidity within the fixed-income market since the financial crisis may be one of the reasons this latest correction has been particularly brutal. Recent regulatory changes and tougher reserve requirements have inhibited the big Wall Street banks from maintaining large inventories in corporate bonds and probably municipals. According to the Federal Reserve Bank of New York, corporate bond inventories at primary dealers peaked at $200 billion in 2007 and have since tumbled to a mere $50 billion, even as the size of the corporate market has grown significantly. Richard Prager, head of trading at BlackRock, was recently quoted as saying: “(…) there’s not enough balance sheet on the ’sell side’ to support any kind of warehousing activity if institutional investors want to materially reduce their holdings.”
While we haven’t seen similar data regarding municipals, it wouldn’t be much of a stretch to assume that tax-exempt inventories have followed a similar trajectory. This is particularly true now that tender option bond programs, which used to allow dealers to profitably leverage their inventories, are no longer as prevalent.
Market illiquidity can also be compounded by a lack of transparency. A recent Bond Buyer article points out sharp divergences among the various services that provide traders with benchmark yield scales (Thomson’s Municipal Market Data, Municipal Market Advisors and Bloomberg) during periods of market illiquidity. Due to their differing methodologies, each scale provider may come up with a different rate change scenario on any particular day, particularly if actual trading volume is low. It does appear that MMD and MMA generally track each other while Bloomberg, as the new kid on the block, still needs to validate its approach. At the end of the day, as long as investors stick with a consistent benchmark (regardless of which one they choose) and adjust their spreads accordingly, they should all come up with fairly close results.
In spite of the current doom-and-gloom, once the fund redemption scenario is allowed to play out, we believe investors will once again recognize the attractive relative value that municipals do represent. We suspect that this may happen before we have to fire up our grills for the July Fourth celebration.
Today’s a big day for Detroit creditors as they’re scheduled to meet with and presumably get the bad news from Emergency Manager Kevyn Orr. Already, all the rating agencies have pre-emptively downgraded Detroit in anticipation of a debt restructuring. Standard & Poor’s, for instance, has lowered its rating on Detroit’s unlimited and limited-tax G.O. bonds and pension obligation certificates to ’CCC-’ from ’B’, with a “negative outlook” to boot. Moody’s even dropped the water & sewer system, thought to be relatively insulated from any restructuring, to below investment grade: Ba1 on the senior-lien debt and Ba2 on the second-lien debt.
Oh yes, and Meredith Whitney is out with another book about municipal finance, something about states with lower tax rates and business-friendly regulation potentially outperforming other states. Surely, this can only be a revelation to someone who, by her own admission, “never focused on the muni market.”
Oh yes, and Meredith Whitney is out with another book about municipal finance…
A quick look at the new book’s Table of Contents reveals how out of touch she is with our market: Chapter 4 is entitled “Pensions: The Debt Bomb Nobody’s Talking About”. Really? Meredith, that is ALL we muni people have been talking about, ad nauseaum in fact. As initially announced last year, the book was going to focus on the fiscal plight of local governments but somehow it mutated into a political pamphlet about Red States versus Blue States. Frankly, Ms. Whitney should have stuck with her original theme. In our view, that would’ve made for a much more interesting read.
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