The Muni Market Moves Forward

The Muni Market Moves Forward October 4, 2010, John Mousseau, CFA, Vice President & Portfolio Manager

The third quarter of 2010 witnessed a tax-free bond market in which nominal yields moved lower.

YIELDS

Viewed in percentage yield terms, the 10-year yield ratio moved from 103.1% to 104.3%, but the 30-year ratio actually dropped from 115.2% to 113.2%.  In addition, some high-grade tax-exempt issues are trading through these scales.  We believe the Federal Reserve will remain on hold until well into 2011, in regard to raising short-term interest rates.  We also believe inflation will remain low.  Both of these are clear drivers of some of the asset flows into fixed income in general and taxable BABs and tax-free bonds in particular.

BABs

Build America Bonds (BABs) continue to take away tax-free supply as issuers use BABs to finance eligible programs. Since early August, longer Treasury yields are down 30 basis points in yield (and were down 50 basis points at one point) as the Federal Reserve’s quantitative easing program has driven interest-rate expectations lower.  Therefore, even though spreads of BAB issues are wider than they were early in the year, the NOMINAL borrowing levels enjoyed by municipal issuers are lower, when the 35% subsidy is figured.  For example, the Salt River Arizona Power District (AA1/AA) came to market this week with a $500-million deal at a +115-basis-point spread to the 30-year Treasury bond.  This translates into a nominal yield of 4.84% and, when the 35% subsidy is taken into consideration, that is an effective borrowing cost of 3.15% – easily 75 to 90 basis points lower than if bonds were issued in the tax–free bond market.

It is quite evident that economics favor BABs issuance for municipal entities.  However, at this point, the BAB program is slated to expire at year-end.  There is a proposal to extend BABs through the end of 2011, albeit with a lower subsidy rate of 32%.  We do believe that Congress will vote to extend BABs, but this may not occur until after the mid-term elections, in the lame-duck session.  We think this uncertainty is one reason why BABs underperformed the corporate bond market during the quarter.  Clearly, if Congress DOES NOT extend the BABs program, it should cause tax-free issuance to pick up considerably (but probably not to the extent that BAB issuance had, because some projects are economically feasible at the lower subsidy rate than at a higher nonsubsidized nominal rate.  Our opinion is that existing BABs would tighten considerably to the market.

CREDIT

It has been a roller-coaster quarter regarding municipal credit, as concerns over big-name states like California and Illinois have risen again.  California just passed their budget, while the Illinois legislature must still do so.  In addition, developments in Harrisburg, PA continue, as the city has asked to be included in a state program for troubled municipalities.  The credit concerns have manifested themselves more in the BAB market than in the tax-exempt market, for reasons that are completely supply-driven.  However, on a quarterly basis, NOT MUCH CHANGE.  For example, spreads over Treasuries on long-maturity California GOs moved from 290 to 305 during the quarter, while spreads on long-maturity Illinois GO BABs moved from 320 to 315, albeit with a lot of volatility during the quarter.  Meanwhile, long tax-exempt California and Illinois GOs moved perhaps 10 basis points wider off the long tax-free scales during the quarter.  In other words, the bond markets are telling a different story than the newspapers and general press.

There are a number of concerns in Muniland:  strained budgets, underfunded pensions, OPEB, etc.  We will reiterate that what happens in Harrisburg, Pennsylvania with an ill-conceived incinerator is not relevant when analyzing the Kansas Turnpike Authority, the State of Washington, or any of the myriad municipal issuers that are trouble-free.  States are beginning to address pension problems with various solutions, such as extensions in retirement age and changes in cost-of-living adjustments.  There is time to correct these problems.  In some instances, usage fees and taxes are being raised.  And it is important to remember that we have had a SMOOTHLY functioning municipal market in both BABs and tax-exempts during the worst recession since the Great Depression.  The economy will improve over time, and that will certainly enhance budget balancing.

GOING FORWARD

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