Last Friday, the fixed-income market reacted in rather surprising fashion to a very strong April employment report: it actually rallied, pushing the benchmark yield on 10-year Treasuries down near the low for the year at 2.58%. Apparently, the positive gains in payrolls are being ignored by market participants, who seem more troubled by the historically low labor participation rate and by the still-evolving Ukrainian situation. Although it’s difficult to discern cause and effect at this point, a shaky performance from the equities market over the past week, particularly in the tech sector, has also helped bolster flows into bonds.
Despite Janet Yellen’s insistence in her testimony to Congress yesterday that much of the first quarter’s anemic growth is weather-related, the market is still convinced there is an undercurrent of economic weakness out there which is not entirely attributable to the Polar Vortex. As spring finally arrives in most parts of the country, we’ll soon find out if this belief is warranted.
New Issue Market
Muni investors will have to contend with another week of scarce supply. On the investment-grade side, the most notable offering will be a $450 million revenue issue from the Illinois Toll Highway Authority, a Aa3/AA-/AA- entity.
High yield investors may take a look at the latest $308 million special facilities refunding issue from Houston Airport, now backed by the newly-merged combination of United Airlines and Continental Airlines. Although we’re comfortable with the new United’s credit outlook at this time, the proposed yield of 5.25% for the longest bonds maturing in 2029 strikes us as quite rich. A spread of about +242 off AAA is rather underwhelming for a B2/B credit in a non-specialty state. Unless you have cash burning a hole in your pocket, when yield levels on B-rated issues get down to the 5 percent handle, it’s usually time for caution.
Puerto Rico Update
Analysts looking for signs of stress in Puerto Rico’s banking system need look no further than Doral Financial Corporation (DRL). DRL’s stock price has cratered by 72% since the Puerto Rico bank announced on Friday that the Federal Deposit Insurance Corp. (FDIC) had determined that tax receivables from the Puerto Rico government (about 43% of the assets it had been using to calculate its 2013 Tier 1 capital ratio) no longer qualify toward its capital ratios. So, tax receivables from the Island are no longer considered a high-quality asset? Who would have thought?
Of Michael Lewis And Today’s Muni Market
On the flight down to Baltimore for a recent conference, I finally had the chance to finish the latest book from Michael Lewis, “Flash Boys: A Wall Street Revolt.” As many of you know, the book has sparked a storm of public outrage with its assertion that the US stock market is effectively “rigged.” At the center of this new controversy is the role of the so-called “High Frequency Traders” (HFT), firms that attempt to exploit the time lag between an investor order’s entry and its eventual execution on the various exchanges. In these days of electronic trading, this time lag is expressed in milliseconds, much faster than you and I can physically imagine. Through complex computer algorithms and state-of-the-arts fiber optic connections, HFT traders can literally get inside that millisecond execution gap and effectively front-run any large, market-moving stock orders. I’m sure there are more complex aspects to this issue, but that’s the general gist of it.
In fact, I think [Michael Lewis] may have singlehandedly created a new non-fiction genre, the “financial morality tale.”
The other topic usually mentioned in the same breath as HFT is the so-called “dark pool liquidity.” “Dark pools” are generally defined as private exchanges for trading securities that are not accessible to the general investing public and do not comply with disclosure rules associated with public exchanges. As their rather ominous name suggests, dark pools are characterized by their lack of transparency. As such, they appeal mostly to major institutional investors looking to execute large block trades: in theory, the lack of transparency should help the investors achieve better execution anonymously without running the risk of tipping their hands to the market at-large. Ironically, the same lack of transparency could also work against these investors by potentially exposing them to predatory practices from broker-dealers or HFT traders, since no one really knows what happens in the “darkness.”
As a fixed-income geek, I certainly don’t feel qualified to take sides in the raging debate about the impact of HFT trading. Whether or not I agree with Mr. Lewis, I do admire his talent for writing about fairly arcane subjects in dramatic and yes, entertaining, fashion. Even though he has written about other topics, most successfully about baseball (“Moneyball”) and football (“The Blind Side”), Michael Lewis really shines when he tackles issues in the financial markets, ever since he started his writing career with the now-classic “Liar’s Poker” back in 1989. In fact, I think he may have singlehandedly created a new non-fiction genre, the “financial morality tale.”
All this got me thinking about what morally outrageous behavior Michael Lewis could uncover in today’s municipal bond market. Of course, the very notion of “high frequency trading” is quite laughable when it comes to munis, which basically trade by appointment. Just ask any muni trader who just went at risk by showing an aggressive bid to a client, only to sit and wait for hours before getting a response from such client. To compete solely on trade execution speed implies a fairly efficient market, something still not within reach of our market. And then there’s the perennial problem of inconsistent liquidity: there’s always a burst of liquidity when a new muni issue comes to market, and then all the trading activity tapers down to nothing once all the bonds are placed with the ultimate buy-and-hold investors. Having said that, I am aware of various efforts to bring algorithmic trading to the municipal market, so I could be proven very wrong very soon.
Dark pool liquidity, on the other hand, is being seriously considered by major institutional fixed-income investors, particularly in the corporate and high yield arenas. This is in response to a decade-long decline in secondary market liquidity, as dealers continue to reduce their bond inventories and the banks are now required to shut down their proprietary trading desks. Again, in theory, a dark pool may provide a way to match buyers directly to sellers without the information leaking out to the general market.
Already, TMC Bonds, backed by a consortium of Wall Street dealers and bond insurer Assured Guaranty, has announced the launch of the Codestreet Dealer Pool, designed to allow dealers to trade corporates, high yield and even distressed paper among themselves.
If efforts on the corporate side are successful, it will be only a matter of time before the experiment is expanded to include some sectors of the muni market. TMC Bonds is, after all, best known for running The MuniCenter, an electronic trading venue for municipals.
Arguably, the municipal market severely underperformed its taxable counterpart last year because a handful of institutional players failed to deliver on their most basic promise to their shareholders: portfolio diversification.
If you think all this runs counter to current efforts by the regulatory agencies to improve market transparency, you’re absolutely right. It will be interesting to see how the regulators will deal with these market innovations, particularly given their mandate to protect the individual investor. For instance, without full transparency, a retail buyer will have no way of knowing what the real value of her bonds is. She may step up to buy a bond at a certain price, based on public trade information, only to find out later that the same issue traded in size at a much lower price through a dark pool. Smaller money managers and RIAs may face the same problem.
If I were Michael Lewis, I might also write about the colossal failure in risk management that Puerto Rico represents. Arguably, the municipal market severely underperformed its taxable counterpart last year because a handful of institutional players failed to deliver on their most basic promise to their shareholders: portfolio diversification. When specialty fund investors realized that their funds had as much as a 40% exposure to what ended up being a single “junk” credit, they voted with their feet. Massive fund redemptions ensued, which begat even more redemptions. This was the source of the “systemic risk” we all now have to deal with. Truly, in this case, the sins of the few ended up hurting the entire industry.
Mind you, Mr. Lewis has taken on the municipal market before, in the very last chapter of “Boomerang,” his 2011 travelogue through the wreckages of the Great Financial Crisis. In that chapter, he gave a fair treatment of state and local governments’ daunting fiscal and pension issues, some of which are still being worked out today. Unfortunately, like many others in the media at the time, he couldn’t resist the sensationalist urge to make a heroine out of “She-Who-Shall-Not-Be-Named,” the bank sector analyst who somehow felt qualified to predict hundreds of billions of muni defaults over the next few years. (One can only hope that the market’s verdict will be kinder to EIX’s Brad Katsuyama, the current hero of “Flash Boys” than to her.)
There is much that we as muni market participants can do to improve the fairness and efficiency of the tax-exempt market and protect the ultimate buyers, the retail investors. Let’s not wait for somebody like Michael Lewis to turn our market’s shortcomings into national headlines.
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