The Treasury market finally found short-term equilibrium this week, primarily on the back of the continuing correction in global equities. Once the yield on 10-year Treasuries hit a fresh 22-month high at 2.67% on Monday, buyers did emerge. Renewed efforts from Fed officials, particularly from the trio of Dudley, Kocherlakota and Fisher, to clarify their message and reduce market anxiety also appear to be working.
So far, this week’s economic releases appear to support the Fed’s confidence in the economic rebound. Durable goods orders reportedly rose 3.6% in May (up 0.7% ex-transportation). The housing recovery in particular remains in full swing: May new home sales were up 2.1% and the Case Schiller Index in 20 U.S. metropolitan areas rose 12.1% in April compared to a year ago. Of course, these data points pre-date the latest surge in mortgage rates, so there is room for skepticism about their sustainability.
Even with the Treasury market regaining some measure of stability, the damage done to the credit markets has already been extensive. New issue volume on spread products such as high yield corporates has ground to a halt. Bond fund managers are still dealing with the delayed effects of investor redemptions. In many cases, they are finding out that their worst fears about market liquidity have been realized.
New Issue Market
Faced with a buyers’ strike, the last thing the muni market needed was a surge in supply. Unfortunately, this week’s calendar is shaping up to be a whopping $10 billion, with issuers rushing to take advantage of rates that are still historically attractive. Thus, it’s not surprising the market went through another selling paroxysm on Monday, resulting in another 18-20 bp adjustment across the AAA curve. The 10-year yield on the Municipal Markets Data scale now stands at 2.80%, the highest since May 2011.
Actual trades paint an even bleaker picture. For instance, an institutional size block of Austin Electric Utility Revenue Bonds 4.00% 11/15/2031 (cusip 052414mw6) that came to market on 12/1/12 at 109.864 (2.85% yield to call) retraded yesterday at 88.479 (4.96% yield), a stunning 19.3% loss in just six months. The high premium original issue price was designed to be defensive and to provide some cushion in the event of a selloff, but that was all but erased by the swiftness and magnitude of the current market correction.
Of all the names, Illinois stands to be the most heavily penalized under current market conditions.
Interestingly, the largest long-term issues on this week’s docket are all “high yield” names which may not be particularly rate-sensitive: they include another $1.26 billion unrated fertilizer facility from Posey County, IN, a $638 million Louisiana Tobacco Refunding deal and of course, that high yield icon, the State of Illinois, with a $1.3 billion G.O. offering.
Of all the names, Illinois stands to be the most heavily penalized under current market conditions. With a potential conference committee vote on pension reform not scheduled until July 9, there is very little good news on the credit front to help this week’s deal. Given its backlog of unpaid bills and its pressing infrastructural funding needs, the state does not have the luxury of waiting for more favorable pricing conditions. However, to the extent Illinois already trades like a BBB name, further spread widening should be viewed as an opportunity, in our view. Current price talks are centering around the +175-200 basis points off AAA level for a 20-25 year maturity, which we would view as an attractive relative value for a State G.O. credit with very strong bondholder legal protection.
We do think the last 50 basis points or so of the current market move was purely driven by liquidity factors, exacerbated by short-term technical factors such as quarter-end window-dressing etc… On that basis, there are reasons to believe the market will stabilize once we manage to get past this week. After all, the last time tax-exempt yields stood at these levels was 2011, well before the latest round of federal and selected state income tax increases which kicked in at the end of 2012. This means that taxable equivalent yields are that much more attractive this time around, particularly for residents of high tax states such as California.
ETF Liquidity in Question
Last Thursday, as selling pressure in the bond market accelerated, State Street Global Advisors was forced to temporarily suspend cash redemptions for their muni ETFs (co-sponsored by Nuveen). Such a move, however, didn’t affect the ETF shareholders who trade their shares on the open market. It only affected the broker-dealers who made markets in those ETF shares and who needed to redeem their shares.
Normally, market makers who wish to redeem their shares on behalf of their investors can be paid either “in kind” or in cash. If they choose in-kind redemptions, they will receive in exchange for their shares a basket of municipals that the fund has posted as deliverable to key market makers. It is important to note that they will not receive a pro rata slice of all the securities in the fund, just the securities that have been posted. With the cash redemption option, the fund’s manager will come up with the cash by selling some of the more liquid holdings in the portfolio.
Last Thursday, muni ETF market makers only had the “in kind” option available, meaning they had to take delivery of the deliverable basket of bonds in exchange for their shares. This, of course, had the effect of shifting the market/liquidity risk from State Street onto those dealers. The cash redemption option was reportedly restored on Friday, which meant State Street was once again on the hook for selling enough securities into a free-falling market to meet cash redemptions.
Muni ETFs were not a significant factor in the marketplace back in 2008, the last time we went through a liquidity crisis of this magnitude. How they fare this time around will bear close monitoring.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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