6/08/07 by Matthew Posner, The Bond Buyer
Absolute municipal bond yield levels have been rising for the last month and it is changing the way traditional investors are approaching the market. Next week is likely to see a drop in volume that will pose several new dynamics that haven’t been seen in the marketplace since late last summer.
“We are at the highest yields we’ve seen this year, and I don’t think we’ve been at these yield levels for some time,” said Paul Brennan, portfolio manager at Nuveen Investments. “There is some opportunity to get back into [the market].”
Looking at Municipal Market Data’s triple-A, 30-year general obligation bond scale, on Wednesday it was at 4.32%, the highest yield since Aug. 17, 2006, when the 30-year yielded 4.33%. The same trend is seen with the 10-year bond, which on Wednesday was quoted at 3.98%, the highest yield since Aug. 1, 2006, when it yielded the same amount.
This movement is largely attributed to the Federal Open Market Committee’s concerns over inflation, which greatly devalues bonds. After the FOMC’s May 9 meeting, it issued a statement saying, “core inflation remains somewhat elevated. In these circumstances, the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.”
While this is no major change in position from its prior statements, the market finally came to adhere to these concerns. From May 9 through June 6, the benchmark 30-year triple-A bond yield jumped 23 points and the 10-year bond yield rose 24 basis points.
Yesterday, the slow rise in yields went into high gear as the European Central Bank raised interest rates that led to several large mortgage-backed funds selling off treasuries in large volume. As a result the benchmark Treasury 10-year yield rose 14 basis points, the biggest yield increase in over a year.
“There is no question that the Fed has grounded it in our heads that inflation is an issue,” said Bill Hornbarger, chief fixed-income strategist at A.G. Edwards & Sons Inc. “Today we jumped because of global events, but yields moving up is a momentum thing right now caused by a lot of position trades, and it is anybody’s guess as to when this momentum and turns the other way around.”
This sets the stage for an interesting municipal market heading into next month, as the extent of how much weakening of the market will occur is still up in the air. A dynamic that could begin to play a role in munis as a result of this is the influx of retail buyers. In the past year or so, many retail buyers have bowed out of investing heavily in tax-exempt debt because of low yield levels.
“It ought to entice retail buyers to jump into the municipal market because lately we’ve seen levels where there is very little relative value,” said Rick Calhoun, first vice president of retail sales of Crews & Associates that is based in Arkansas but caters to several southern states. “As you approach 4% in the middle of the curve and even some 5% yields on the long end, which retail traditionally gravitates to, we should see a lot better buying from retail clients.”
Bill VanLandingham, who does institutional and retail sales at City Securities Corp., said that the seasonal trend of many buyers reinvesting at this time of year will also change the market. “We see it is as a buying opportunity, we are getting to an interesting period as July 1 coming up when you get a lot of called and matured bonds,” VanLandingham said. “There are a lot of muni dealers across the country that are stuck with inventory so it is going to make it a little interesting over the next couple of weeks, as you’ve got seasonable buying opportunities and on the other hand a glut of paper, so it is going to be a buyers’ market.”
Brennan echoed this thoughts, noting that this is redemption season, which will provide “technical support” to the market meaning that a lot of excess cash flow will get recycled into the system, hopefully helping munis out perform their taxable counterparts.
As yields rise, however, a major driving force in high volume levels in the market place so far this year — refundings — could beginning to slow down.
Dick Berry, chief investment officer of the tax-exempt group at AIM Adviser Inc. said he wouldn’t be surprised if volume were to slow down a bit as many issuers who thought they could save money refinancing their debt no longer see the value. On top of that, Berry said that “the summer months are normally slow so while we had good volume this week, I expect it to slow down.”
Calhoun also warned that a decline in refundings will quickly turn the market the other way. “It has become more expensive for issuers to refinance so you are going to see supply pull back a little and with that we could see bonds get expensive, which will change the way retail buys bonds.” There are two events next week that could likely act as harbingers as to where the market is going. First, the primary market could see some interesting developments. A pending sale of $1.5 billion of Puerto Rico general obligation bonds is on the day-to-day basis, if these is pulled from the block next week, it could be a sign that many issuers are going to wait out current market conditions. Second, the May producer price index and consumer price index data is set to be released on Thursday and Friday of next week, respectively, both major inflation indicators. If one or both go much higher than consensus, yields could continue to rise.
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