The Bond Buyer
August 3, 2009
The yield curve - a graphic depiction of how steeply interest rates ascend with longer maturities - expresses the extent to which the market favors short-term munis over long-term ones. Today's municipal yield curve shows the market favors short-term munis over long-terms quite a lot. Triple-A munis at the 30-year point of the Municipal Market Data scale yielded 400 basis points more than two-year triple-A munis yesterday. The 30-year-over-two-year slope exceeded 400 basis points last month for the first time since 1982, according to MMD. One year ago, the slope was 73 basis points. The average slope since the early 1980s is about 215 basis points, MMD says.
The steepness stems more from depressed yields on short maturities than elevated yields on long maturities. George Friedlander, municipal strategist at Morgan Stanley Smith Barney, wrote in a report last week that munis with maturities from six months to six years are "extraordinarily rich."
Based on the MMD curve, the two-year triple-A closed yesterday at 0.79%, the slimmest yield since MMD started keeping track in 1981.
Short-term muni rates are also depressed relative to benchmark rates, Friedlander said. At 0.79%, the two-year triple-A yield is 66.4% of the Treasury yield, which is just shy of a record low. A year ago it was 86%, and the average since the early 1990s is 78%, according to MMD.
A confluence of factors has yanked short-term rates to the floor. One is that some of the products once vital to the short-term muni sector have imploded. Because obtaining the necessary letter-of-credit backing has become more difficult and expensive, sales of variable-rate debt have tumbled 78.2% so far this year, according to Thomson Reuters. That represents a decline of more than $9 billion in issuance a month on average.
After a wave of failed auctions in 2008, the auction-rate securities sector is moribund. The collapse in supply of short-term notes has done nothing to dampen demand, said Jeffery Timlin, a portfolio manager at Sage Advisory Services.
The result is "a ton of buyers at the front end of the curve clamoring for paper," he said.
Another curve-steepener: some of the cash that darted for safe havens during the throes of the credit crisis has re-emerged in search of higher returns.
Money that had been left in cash or at the bank is now in short-term bonds, bringing rates down at the front of the curve.
According to the Federal Reserve, households had $7.88 trillion stored in bank deposits and money market funds at the end of the first quarter. Friedlander has argued for months that money will not stay there forever. Though these safe havens offer unassailable security, Friedlander said, they also offer painfully low returns.
The average savings account yields 1.2%, according to Bankrate.com, while money market funds routinely yield fractions of a percentage point. People will grow intolerant of these yields before long and put it to work in riskier assets, Friedlander has said. It would not take much run-off from a multi-trillion-dollar mountain of cash to overwhelm supply in a municipal market on pace to issue less than $400 billion in debt this year, Friedlander said.
The reversal of the flight to quality in 2009 has chased $167.5 billion from money market funds, according to iMoneyNet, including $43.5 billion from tax-free money market funds.
Much of this money has landed in muni mutual funds. According to AMG Data Services, investors have entrusted more than $37 billion to muni funds in 2009, driving the industry to record assets under management.
That would intuitively lead to a flattening of the yield curve, except for what Friedlander calls the "hidden structure" of muni fund flows.
While many investors are fed up with the dreadful yields in money market funds, they remain unwilling to take "significant risk," according to Friedlander.
That leads them to the short-term muni market.</p>A lot of people do not realize that most of the money flooding municipal funds is hitting limited-term and intermediate-term funds, not long-term funds, Friedlander said.
Less than a third of the money that poured into muni funds since they became a magnet for cash in mid-January has gone to long-term funds, according to AMG. The rest is going to short and intermediate funds.
Of the 25 funds with the heaviest inflows this year, seven have the word "ultra-short" in their name, including the top two. Five more are "short," and one other invests in variable-rate demand obligations with rates that reset weekly.
Matt Fabian, managing director at Municipal Market Advisors, in his weekly report noted "clustered buyers at earlier maturities." He attributes this to the cash exodus from money market funds, the Fed's campaign to keep interest rates near zero indefinitely, people seeking shelter from a turbulent stock market, and jitters over credit for some issuers. Fabian called munis with maturities of one to five years "substantially overbought."
Meanwhile, yields on the long end of the municipal curve are historically high relative to Treasuries and historically low relative to their own history. Based on the MMD yield curve, the 30-year triple-A yields 110.2% of Treasuries. That is down significantly from the record in December 2008, but still higher than any ratio before last year.
This, too. is the result of a confluence of factors.
Friedlander cited a tough stretch for the property and casualty insurance industry, which keeps about 29% of its financial assets in municipal securities, according to the Fed.
The P&C industry lost $1.3 billion in the first quarter as it was slammed by weak prices for insurance premiums and tumultuous financial markets, according to the Property Casualty Insurers Association of America.
Insurance companies without taxable profit have little reason to sock their cash into tax-exempt investments.
Property-casualty insurers own roughly $375 billion of municipal debt, according to the Fed, or roughly 14% of the outstanding supply.
The industry has purchased an average of $2.72 billion in munis a quarter for the past year and a half. From 2003 to 2007, the industry bought $9.42 billion a quarter on average. The tender-option bond programs that earlier this decade arbitraged the municipal curve's steepness also used to be a significant buyer at the long end of the curve. After the hedges needed to implement the TOB strategy blew up during the credit crisis last year, long-term munis lost a crucial pillar of buying power. Matt Dalton, chief executive officer at Belle Haven Investments, said two fears have driven buyers out of the long end: inflation and bad credit.
In either case, it is better to hide out in short-term debt than risk being stuck with a 30-year bond saddled with atrophying purchasing power or the prospect of default, he said.
In spite of the lofty yield relative to Treasuries, at 4.68% the 30-year triple-A is too far from the magic 5% yield to tempt retail buyers, Dalton said.
