The Muni Market a Year (and change) After the Lehman Failure (What a Long Strange Trip It’s Been)? October 20, 2009 John Mousseau, CFA, Vice President & Portfolio Manager
John Mousseau is a portfolio manager and heads the tax-free Muni section of Cumberland. He is a member of the Management Committee of Cumberland Advisors. His bio is found at www.cumber.com. His email is John.Mousseau@cumber.com.
A year ago the failure of Lehman Brothers (which we believe was avoidable, with responsive Federal Reserve action) sent the tax-free bond market into a world that was unrecognizable to most market participants. We thought it would be instructive to see where the market has come during the year and posit where we think the municipal bond market is heading.
Source: Bloomberg
Here is the AAA tax-free yield curve the Friday before Lehman Brothers failed last year (white line), in the middle of the hedge-fund meltdown in October (red), at the end of the year (yellow), and now (green). The market has gone from a total meltdown with little liquidity to long-term tax-free yields that have not been this low since 1967. A quick roadmap of the plunge into the abyss and climb back out is in order.
By the time Lehman Brothers failed, the municipal market had been buffeted by illiquidity, a downgrade of most of the bond insurers, and what (in retrospect) was a mild blowup of municipal hedge funds in February of 2008.
October 2008 (early)
Hedge Fund Blowup 2: With short-term markets in disarray in the wake of Lehman Brothers, muni hedge funds (who take advantage of the traditionally steep tax-free yield curve, with borrowed money in a high degree of leverage) again saw large call on their money by their lenders. Unmitigated selling in a market with almost no buyers and no Wall Street bids causes yields to rise over 100 basis points in a week.
October 2008 (third week): With the unprecedented rise in yields, buyers emerge voraciously and yields drop almost 150 basis points the following week – a roller coaster such as the muni market has never seen.
November 2008: The Fed begins to buy longer-dated Treasury and agency securities in an effort to bring down longer-maturity yields, with the goal of “dragging” other non-Treasury yields (munis, corporates, and mortgages) along with it. Initially this just causes the gulf between Treasury and muni yields to widen even more.
December 2008: Credit concerns hit the high-yield muni market and there are forced liquidations at a number of high-yield funds. Because they’re unloading the highest “quality” they can to raise funds, this forced selling brings all high-grade muni yields higher. Recognition of this cheapness rallies the market back somewhat towards year end.
January-April 2009: There is a “calming” effect on the municipal bond market. The market is learning to live without the overwhelming presence of bond insurance. With the exception of FSA and Assured Guaranty (now merged) and Berkshire Hathaway (Warren Buffet’s muni insurer, which in fact has not insured very much) all the other insurers have stopped being a force in the market. Bonds with these other insurers are all trading to the underlying ratings. Thus, in many cases, bonds with poor or no underlying ratings trade (when they trade at all) like junk bonds.
However, for the first time in years, municipal bond funds are seeing inflows. Equity markets continue to slump until March, but the forcing down of long-term yields by the Fed is starting to pay off, as yields on other instruments, including munis, corporates, and mortgages, continue to fall, from 6% down to 5.25% for long-dated tax-free bonds. It was the unfreezing of the debt markets that allowed equities to start improving in March.
May-July 2009: The stimulus program has helped munis on two fronts. So far the smaller effect is the allowing of banks to buy up to 2% of their net assets in munis issued this year and next AND write off the interest costs for carrying munis. Banks lost most of their ability to deduct 80% of their carrying costs with the Tax Act of 1986. This certainly spurs on demand for new issues.
The second effect is from the Build America Bonds (BABs) program. This allows issuers to issue bonds (for new projects) in the taxable bond market and receive a 35% interest subsidy from the federal government. Build America Bonds (BABs) come into the taxable bond market. A product of the federal stimulus plan, BABs are allowing municipal issuers to sell TAXABLE municipal bonds for which the Federal Government is subsidizing 35% of the interest costs. BABs have been coming (at least initially) at very generous spreads over US Treasuries. Taxable buyers such as pension funds, endowments, and charitable foundations have all flocked to own BABs, as the yields have been higher than high-grade corporates but with a perceived (and real) higher credit quality due to the resources of municipalities versus those of corporations. It has also been great for the issuers, as their true cost of issuance has been much less than it would have been in the equity market.
A quick example is illustrative. In mid-April, the University of Virginia came to market with a 250mm BABs deal with a 6.20 yield. This was attractive to buyers, especially since the 30-year Treasury was a 3.75% at the time. University of Virginia is also an AAA issuer on its own, without any credit enhancement (a rarity among colleges). The cost to the university was not 6.20% but an effective 4.03% after deducting the 35% subsidy of the federal government. At the time the tax-free market for the university would have been effectively 5% (which means that less gilt-edged credits were yielding decently more than that). The tax-free market views this transaction and realizes there is no incentive for issuers to come to the tax-free market as long as they are saving a full 1% or more by issuing their debt as BABs. Thus tax-free supply starts to fall and, more importantly, PERCEIVED future supply also drops. This begins the drive towards lower tax-free yields as buyers begin to scramble.
August-September 2009: The BABs phenomenon continues and accelerates greatly in September. Tax-free yields cruise through 5% and keep dropping lower. AAA yields start to approach 4% in the long end – levels not seen since the Johnson administration. The driver for this has been the dropping of spreads on BABs deals. The same UVA deal that came at a 6.20 (or 245 basis points over long Treasuries) is now yielding approximately 5.055, or 100 basis points over Treasuries. Thus, the BABs after-subsidy rate has been dropping and tax-free bonds have been rushing downward in an attempt to keep up. At the same time, municipal bond funds (both general and high-yield) are seeing fund inflows on a scale they have not seen since 1993. Not only has this driven yields lower, but credit spreads, or the difference in yields between bonds of similar maturities but different ratings, has been narrowing as investors search for incremental yield.
October 2009: The muni market hits its first bump of 2009 as yields on AAA paper approach 4-4.25%. Though still “cheap” relative to US Treasuries, the low nominal yields have caused sticker shock among retail investors. This backup has returned some value to the muni market.
Where do we go from here?
Cumberland is beginning to get somewhat more defensive on the tax-free municipal bond market. This is a recognition that the market has run a long way from the days of last year’s fourth quarter, when there were few buyers at any level. We favor premium bond structures where we can obtain what we think are favorable prices. This is because of the fact that the tax-free municipal market and the US Treasury market have moved closer together, setting up the possibility of advance refunding of older, higher-coupon bonds by issuers. This provides present-value savings to issuers and lowers long-term debt-service costs. We do think that a more defensive posture will pay off as we move into the latter part of 2009 and 2010.
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