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The secondary market for tax-free municipal bonds works well, except when it doesn't.
And the market hasn't been working very well since Labor Day. It was then that news articles about the precarious fiscal conditions of states like California and municipalities like Harrisburg, Pa., provoked a wave of selling, especially among retail customers, who hold close to 70% of municipal securities outstanding in the form of bonds and mutual funds. Investors leaping en masse over the rail are diving into what Thomas Doe describes as "inconsistent liquidity." In other words, because there are more sellers than buyers, their bonds are worth less than their most recent brokerage statements would lead them to believe.
Doe is the founder and chief executive of Municipal Market Advisors, a research firm. Last week, in a chilly basement auditorium at the Securities and Exchange Commission headquarters, he was a member of a panel of experts sharing its insights at an agency "field hearing" on the state of the municipal- securities market.
The experts contend the majority of muni-bond issuers aren't as shaky as news reports make them appear. Consequently, contrarian investors might find some gems in the discard pile. This being said, the market will still be subject to uncomfortable episodes of liquidity for a number of reasons. First and foremost, highly leveraged hedge funds aren't buying like crazy anymore. In the wake of the 2007 credit crisis, "leverage" has the taint of a four-letter word. Similarly, banks find themselves constrained from buying as many munis as in the past because of stricter capital standards. Another drag: Institutions and trading firms are more reliant than ever on in-house research, owing to a loss of confidence in the rating agencies. So it takes longer for them to deploy money.
Panel member Alan Greco, managing director of trading and underwriting at Ramirez & Co., a fixed-income portfolio-management firm, says the market performs well when trading volume is between $6 billion and $7 billion. But when it spikes to $10 billion, it takes longer for buyers to step in. This was evidenced in November, when several events roiled the municipal market, including the Federal Reserve's announcement of QE2, its second round of asset purchases; and Standard & Poor's downgrade of $22 billion in state bonds collateralized by payments from cigarette manufacturers to 46 states under a 1998 deal to end suits seeking damages. Buyers sat on the sidelines for five days while yields on top-rated municipal bonds climbed by as much as half a percentage point.
Last week, yields were moving higher again as a result of inflation fears engendered by President Obama's stimulus deal with congressional Republicans. Some high-rated 30-year tax-free bonds were trading over 5%, and some high-rated taxable 30-year municipal bonds were above 7%. Panel member Joseph Deane, a portfolio manager at Western Asset Management, which sells open- and closed-end fixed-income funds, says he's generally a buyer when yields on the long end top 5%.
Why the field hearings? The SEC isn't trying to highlight market risks, says Commissioner Elisse Walter, chairman of the events. Rather, it is on a fact-finding mission to determine if more-frequent and more-detailed financial disclosure should be demanded from issuers. But one thing is already clear from last week's hearing: The municipal market is no longer the place for conservative investors. It has become nearly as volatile as the stock market.
E-mail: jim.mctague@barrons.com
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