The tax-exempt municipal bond market has started its recovery from the great downdraft that hit the market from November 2010 though early February 2011.
We have written about the Meredith Whitney-led wave of municipal bond fund redemptions, amidst her swirling predictions of massive municipal defaults – most recently, last weekend.
The AAA Bloomberg 30-year scales fell from 5.12% on January 14th (peak for the quarter) to 4.76% at close of business March 28th. This represents roughly a third of the rise seen from the end of the first quarter, when that index stood at 4.11.
What has caused the recovery?
Supply – Down
Supply was pushed up into 2010 as issuers flooded the market in the wake of the non-extension of the Build America Bonds (BABs) program in November and December. This took supply away from the first quarter of 2011, which is looking to be the lowest-issuance first quarter in over 10 years. In many states it is tough to find high-quality bonds at market-appropriate levels.
Demand – Up
Market demand was from two sources. Traditionally taxable buyers (pension funds, charitable foundations, IRAs, Keogh plans, foreign buyers) started to buy the TAX-EXEMPT version of the very same credits they had been buying in BABs form.
January saw the phenomenon of yields on BABs FALLING while yields in the tax-exempt form (on the very same credits) were RISING, as tax-exempt funds were being liquidated. Clearly, this indicates two different views on credit from separate sets of buyers. In addition, there is evidence that INDIVIDUAL investors were buying tax-free bonds at the much cheaper prices as fund investors were fleeing.
Credit – Better
Municipalities in total printed their fourth quarter in a row of rising tax receipts, at the end of the fourth quarter of 2010. Both California and New York have had tax revenues higher than forecast. Muni defaults – which have been mostly segregated in the non-rated category (think land deals, nursing home bonds, etc.) – were running 50% LESS than 2010 through the first quarter of 2011.
Also, the spreads on municipal credit default swaps – private money guaranteeing municipal credit – fell during the first quarter. For example, the two whipping boys of the press, Illinois and California, saw their credit default swaps (10-year) fall from 349 to a current 240 in the case of Illinois and 298 to 208 for California. Other states show a similar pattern as this measure of risk drops.
In addition, though LONG-TERM tax-free yields rose severely from November to mid-January, short-term yields rose only a fraction of that. In our view, if there had been true credit problems, those concerns would have reflected across the ENTIRE yield curve spectrum. The damage in the long end (and resulting opportunity) was a result of the TYPES of bonds that tax-free bond funds were selling: intermediate and long-term bonds.
Where from Here?
We expect the current low supply should pick up somewhat as the year progresses. Clearly, issuers who have flexibility are holding off until a lower rate environment returns. U.S. Treasury rates may rise as the economy improves, but it is important to remember that unemployment is still at almost 9% and that, at 4.55%, the long US Treasury yield is still 87 basis points higher than it was at the end of the third quarter of 2010. Thus some additional inflation has ALREADY been priced into the bond market.
We think the likely scenario is that we are in a period of correction from the upside-down world we have been in since the end of 2007, when high-grade tax-exempt bonds started to yield more than comparable Treasuries – all of this occurring during the financial calamities of 2008, which reached their peak with period following the demise of Lehman Brothers. At some point – and it may be well more than a year away – high-grade tax-free bonds’ yields should come under Treasury yields.
Thus the defensiveness of munis is built into the current pricing structure. Tax-free bonds are still a bargain, as municipalities are just starting to right themselves.
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