Traders returning from the Veterans Day holiday are facing a much weaker tone in fixed income as the market continues to digest the implications of last Friday’s blowout employment report. The yields on the benchmark 10-year and 30-year Treasury bonds continue to push upward to around 2.78% and 3.86%, respectively.
Not much by way of market-moving economic data is expected for this week; however, the confirmation hearings for Janet Yellen on Thursday could be a potential source of volatility. Market participants will be scrutinizing her remarks for evidence of a less dovish stance than currently assumed.
The tax-exempt market also backed up in the wake of the payrolls number but did manage to outperform taxables on the long end of the curve. The 30-year AAA scale from Municipal Market Data rose 7 basis points on Friday, compared to the 10 basis point move in Treasuries. Intermediate maturities did not fare quite as well, matching the Treasury move almost basis point for basis point.
… we believe that municipals as an asset class should benefit from an expanding audience, especially at a time when tax exemption is at risk of being curtailed.
Against the backdrop of a slowly but steadily recovering economy, one would expect credit-driven instruments to outperform duration-driven investments. To some extent, that has been the case in high yield corporates. High yield munis, on the other hand, have continued to lag. Barclays just reported that the ratio of muni HY to corporate HY is now at 117%, an all-time high. According to Barclays, “while the increase in ratios reflects the duration differences between muni HY versus HY corporates, we note that HY munis are of higher average credit quality (Ba3/B1 versus B1/B2) and are tax-exempt.” The relative value case for high yield munis is certainly quite compelling.
New Issue Market
Supply should not be a problem for this holiday-shortened week, with only about $5 billion scheduled to come to market. The negotiated calendar is comprised mostly of high-grade non-controversial issues such as the State of California Public Works ($625 million), New York City Municipal Water Finance Authority water and sewer system ($375 million), New Jersey Building Authority ($251 million, taxable) and Virginia Department of Transportation ($278 million Grant Anticipation Revenue Bonds).
A couple of potentially more interesting deals are slated for next week: $174 million Guam Waterworks Authority (GWA) water & wastewater revenue bonds and, of course, the $1.7 billion Jefferson County, Alabama refunding issue, which we will discuss in more details in Friday’s column. We’d be curious to see if the whole Puerto Rico (PR) debacle has either helped or hurt the pricing for other U.S. territories such as Guam. On the one hand, territory debt may see increased demand from mutual funds looking for triple tax-exempt alternatives to PR paper. On the other hand, the PR situation may have brought greater focus on the inherent risks of investing in insular economies.
The new Guam water & wastewater issue is also notable for its split ratings of A- by S&P on one side and Ba1/BB by Moody’s and Fitch, respectively, on the other side. Apparently, there’s quite a difference in opinion among the rating agencies as to whether this credit is of investment grade quality or not. This is even more puzzling since S&P does rate the Guam general government bonds at BB. A quick look at the rating reports reveals that S&P puts much more weight on GWA being a self-supporting essential service utility, with minimal dependence and interaction with the island’s general government.
Do Hedge Funds Belong in the Municipal Market?
At last week’s Bloomberg Conference, the role of crossover investors such as hedge funds was hotly debated: first, in the context of Puerto Rico and secondly, in the context of the municipal market at-large. Their increasing participation in the muni market was viewed by H J Sims’ Dick Larkin as a negative development. At the risk of putting words in his mouth, I believe Dick thinks hedge funds can be a de-stabilizing influence due to their potentially shorter investment horizon, in contrast to the buy-and-hold posture usually adopted by individual investors. However, Hector Negroni from Fundamental Advisors saw this new trend as a necessary evolution of the municipal market, one which will allow munis to become a world-class asset class. An article in this morning’s Wall Street Journal is providing further fodder for debate.
Although we have already shared our opinion in last Friday’s column, we thought it might be worthwhile to expand a bit on our previous thoughts.
Like Hector, we believe that municipals as an asset class should benefit from an expanding audience, especially at a time when tax exemption is at risk of being curtailed. Through the short-lived Build America Bonds (BAB) program, institutional investors, some from overseas, discovered how to integrate the longer maturity of municipal bonds into their asset/liabilities management strategy. Now, with muni ratios hovering around 100% or higher, tax considerations should no longer stand in the way of municipals taking their place at the fixed-income “grown-ups table,” alongside corporates and MBS. The recent increase in taxable municipal supply should also help the municipal bond industry reduce its traditional reliance on retail buyers and their proxies, the bond funds.
To a large extent, the case for munis as a capital preservation instrument has been jeopardized by the rising rate environment and the recent increase in credit concerns.
In the short term, particularly in the case of Puerto Rico, hedge funds have already performed a valuable role by providing much-needed liquidity to our market, at a time when the Street is retreating from its traditional market-making role. Who knows what kind of yields would have been required to clear the market on PR names in early October, had the hedge funds not stepped in? The vicious circle of mutual fund redemptions begetting more selling and thus more redemptions would not have been easy to break. It’s very easy to accuse hedge funds of predatory practices, but surely, every trade had to have a willing seller on the other side?
Given their potentially shorter investment horizon, it’s conceivable that hedge funds could contribute to short-term market volatility, as they’re apt to react quickly and forcefully to any material credit development, in either direction. However, the opposite could also be true. Unlike the mutual funds, who are always net long and can only reduce their exposure by selling, hedge funds can devise creative ways of…well, hedging their exposure and thus may be able to resist selling pressure during adverse market periods.
Although hedge funds should gravitate quite naturally toward distressed and taxable muni opportunities, they may find themselves ill-equipped to deal with the quirks of public finance and the vagaries of the political process. Most will find municipal disclosure practices woefully lagging behind other market sectors. It would behoove these relatively new players to gain a real understanding of how things really work in munis, perhaps by enlisting the help of experienced muni professionals.
To a large extent, the case for munis as a capital preservation instrument has been jeopardized by the rising rate environment and the recent increase in credit concerns. The secular decline in interest rates and insignificant default rate in high grade munis over the last decade has made it very easy to sell munis as a “no-lose” proposition. Arguably, that case has become more difficult to make in recent months. To the extent the current environment lends itself to duration-neutral, alpha-oriented credit strategies, hedge funds should be the natural players to step into the void left by traditional retail investors.
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