One of Verizon Corp.’s most recent slogans is “Rule the Air.” Apparently, the telecom company also ruled the bond market for a few days this week. With the benefit of hindsight, it appears some of the recent spikes in Treasury yields, even after last Friday’s very supportive employment number, have been due to hedging efforts ahead of Verizon’s mammoth $49 billion bond offering. Now that the record-breaking deal is done and the hedges have been lifted, the benchmark 10-year Treasury yield has gravitated back to the 2.90% level.
Going into next week’s FOMC meeting, most of the recent economic data continue to point toward slow but steady growth. Against that backdrop, most market observers expect the Fed to start tapering next week, but at a very timid pace, say around $10 billion to start. Call it a “Mini Taper.”
With tax-exempt rates back at their highest levels in more than two years and a higher marginal top tax bracket for 2013, taxable-equivalent yields are well into double-digit range for many high tax state buyers.
The firmer tone in Treasuries has allowed the municipal market to bounce back more decisively this week, to the tune of 10-12 basis points in the longer maturities over the past two days and another 1-2 basis points this morning, according to Municipal Market Data (MMD).
It helps that underwriters did not take any chance with this week’s new issues and priced them very attractively. One of the issues that caught our eyes was the $278 million Texas Private Activity Bond Surface Transportation Corp. financing. There must have been a yield penalty related to the length of the issuer’s name: the 2043 maturity was offered at a 6 7/8% coupon to yield 7.00% (subject to AMT) or +265 versus MMD’s AAA scale, an attractive level even for a low investment-grade name.
It also helps that the forward calendar has collapsed to a mere $3.5 billion for next week, compared to $5.9 billion this week.
In spite of the recent market strength, outflows from the muni funds continue unabated. The funds that report flows weekly recorded lost another $1.90 billion for the week ended September 11, according to Lipper. Long-term muni bond funds showed outflows $1.04 billion. High-yield muni fund shareholders for their part withdrew $168 million.
Time to Get Excited about Munis Again?
When I started out in the bond management business way back when, one of the first things I learned from my old boss (a quintessential Wall Street trader if there ever was one) was: “you have to know when to go along with the momentum and when to be a contrarian.” Looking at the current muni market through a trader’s lense, it seems to me the time for a contrarian approach is getting closer.
To start, the relative value case for munis has rarely been stronger than now. With tax-exempt rates back at their highest levels in more than two years and a higher marginal top tax bracket for 2013, taxable-equivalent yields are well into double-digit range for many high tax state buyers. For instance, a 5.00% double tax-exempt yield is equivalent to a pre-tax yield of 10.55% for a California resident in the top Federal & State combined tax bracket (estimated at 52.6% in a recent academic study).
Regardless of how attractive munis look on a relative basis, their future performance still depends on the outlook for interest rates in general.
Worried about potential taxability? Tax-exempt AAA munis currently yield much more than taxable Treasuries for maturities longer than 10 years. In the 30-year range, the inter-market ratio stands at 116%, after reaching as high as 120% last week. In effect, over much of the muni yield curve, investors are getting the tax exemption for free.
A recent Barron’s article celebrated the “return of the 5.00% muni bond.” High yield investors can also appreciate the return of the 6.00% BBB muni, all the way up to the 9.00% unrated high yield muni. Just in the span of a summer, investors previously starved for income now have a much greater range of income opportunities to choose from, depending on their risk appetite. The high yield market in particular currently offers an appealing combination of wider spreads and higher absolute yield levels, subject, of course, to competent credit selection.
The muni market’s recent underperformance versus Treasuries has been driven by fear factors, stoked by the relentless media coverage. Yet, one can argue that all the risk factors are now on the table and already well-discounted by the market. The Detroit bankruptcy, for all the publicity it has received, remains a very idiosyncratic situation. It’s true that Motown’s Chapter 9 filing may raise some broader fundamental issues regarding the legal protection for different classes of municipal obligations. But at the end of the day, regardless of the outcome of this seminal case, we will have more clarity, more legal precedents, and more recovery rates to take into account when pricing default risk. That can only be good for the market.
And then there’s the Puerto Rico (PR) factor. Here too, the market’s response has been rather extreme, even considering the island’s dire economic and fiscal conditions. While it’s too early to gauge how this kind of systemic risk will ultimately play out, it’s fair to say the main victims so far have been the institutions with excessive exposure to PR. Should their efforts to reduce their PR stake result in further pressure on PR names, we would view that as a buying opportunity. Perhaps the 10% trade on PR G.O.s earlier this week will be the catalyst that wakes investors up to the opportunities now available in munis?
Of course, there’s always the timing issue. Back only a few months ago, investors chasing record-low yield levels never gave a thought to timing. Now, many are wary of “catching a falling knife.” Still others view the continuing outflows from the mutual funds as an indicator of failing demand and won’t commit new funds until such flows turn positive again. In fact, mutual flow-of-funds will likely be a lagging, not leading, market indicator. The recent market selloff has laid bare the limitations of the mutual fund format and driven many investors into SMAs or into direct bond ownership. We understand some of those savvy buyers have already started to commit funds through the retail market. One would think that, by the time small investors return to the mutual funds, any market rebound will have been well underway.
As a note of caution, September and October tend to be pressure months in the tax-exempt market as reinvestment demand usually slows down and supply tends to rise. Many mutual funds and broker-dealers may also have their fiscal year end in October, leading to some loss of market liquidity. By the same token, the September-October time frame has produced some very interesting buying opportunities in years past.
Based on the above, one can argue it’s only a matter of time before fixed-income buyers, perhaps even a few from overseas, realize they cannot find risk-adjusted yields this attractive anywhere else in the world. Why even venture into volatile emerging markets, when you can find high absolute yields in one of the best functioning capital markets in the world? You may even be able to help your local town or city in the process.
Could it still be too early to call a turn in the market? Absolutely. Regardless of how attractive munis look on a relative basis, their future performance still depends on the outlook for interest rates in general. It’s hard to predict how the Fed’s tapering efforts will actually play out as markets around the globe start to wean themselves from easy money policies. We do have a sneaky suspicion that the equity markets might be more at risk in that event. A potentially significant correction in stocks can only benefit US fixed-income instruments and keep a lid on any future interest rate spikes. Just call us naïve if you want. It could just be that simple a scenario.
In the meantime, we believe it’s not too early for income-driven investors to start capturing some of the most attractive taxable-equivalent yields in years, as long as they do their credit homework and invest incrementally in disciplined fashion. If you need professional help, do seek out investment advisers with demonstrated competence in credit research, a critical skills set for the years ahead.
Thoughts and comments? Write us at firstname.lastname@example.org.
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