DerivActiv MuniMarket Pulse Podcast - Wednesday, March 11, 2009

Tom Doe, Founder and CEO of Municipal Market Advisors reviews February’s muni market performance. Also, seasonal patterns in the municipal market and the trend toward negotiated bond sales. (14 m 30 s)

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Episode Transcript

Jim – Tom, welcome.

Tom – Good to talk to you again Jim.

Jim – After considerable volatility in the financial markets, February seemed more placid. I look forward to discussing the changes in the market conditions and what we might expect this March. Let’s get right to it. The movement in yields during February appeared mixed. Was there an unusual dynamic at work or was it business as usual?

Tom – February is always interesting because historically it’s a time when new issues are bid fairly aggressively, there still is some strong reinvestment by money managers and mutual funds so that creates a bid to the market. January was so strong; there was good momentum that came in to the start of the month. But everybody starts getting a little bit anxious in February. It happens every year because the memories are so clear and vivid of losses that have incurred in March, which we’ll talk a little bit in a minute. What happened in February is municipal price volatility dropped about 50% of what it was in January. What essentially was happening is that absolute yields returned to the lows, and so the strongest, the highest prices that were attained around January 15, those yield lows occurred about around February 13^th because that was Friday the 13^th in February and people were feeling good. But it kind of hit some resistance so when the market got strong the gains weren’t quite as much as they were in January to the upside and what then was happening was when we had a couple of weak sessions as we ended the month is that there was virtually no bid. What was really disturbing about that is that the evaluation services would report the market as being unchanged, when in fact the market could have been down considerably more. As February ended and then as March opened up there was just a loss of any kind of investor interest in the municipal market and all those days where the market was unchanged there wasn’t a bidder now being manifested in much lower prices. We’re entering now into March as we’re recording this and talking, into a very challenging time for the municipal market.

Jim – Are municipal yields still high relative to Treasuries?

Tom – With the ratios, the municipals as a percent of Treasuries, they’re still above 100% but they’re no where near what they were in December when you had the 10-year municipal Treasury ratio at nearly 200. It dropped down to about 111% in February. At that point anybody who was a crossover buyer, someone who was looking to buy municipals as an alternative to Treasuries, an alternative to mortgages, or an alternative to corporates, they were not interested in initiating a new trade. In fact many of those people were starting to get out and we were seeing some secondary selling that was reflective of institutions exiting that particular trade and strategy. Of course they had been handsomely awarded by carrying that trade over year-end and the tremendous strength that we saw in January really lingered. If we look at mutual fund returns Jim, the high yield sector really was leading the returns, maybe up about 7% this year contrasted 50% to 60% in some of the high yield funds in 2008 that were the losses that they had. Investment grade maybe still held on to that 4% or 5% gains year-to-date and of course compared to all of our equity portfolios, municipals are looking pretty good in ‘09.

Jim – MMA has often emphasized the importance of seasonal patterns in the municipal market. Did February follow form?

Tom – The way we measure the market on the seasonal side is we look at the average daily price change for each calendar day. We start with our data that goes back 20 years and then we supplement it with Bond Buyer indice data that goes back to the early 1900’s. What we typically have found is that prices peak in the first quarter, weaken into the end of the second quarter and then the market would tend to improve. I got kind of curious, because without the leverage demand component in municipal market place I wanted to go back to a period of time when retail or individuals was the dominant buyer just as they are now. Which means that they’re very fickle, they get distracted and they have different patterns of investment. So I looked at the period from 1995 to 1999 and looked at what the seasonal pattern was at that time. Interestingly enough, the peak on prices was February 14^th, again as I was saying earlier February 13^th was the Friday, and that was coincidently the turning point in the municipal bond market. We have not had an up session since that Friday the 13^th and the value of municipals has eroded dramatically. It’s very interesting. Sometimes the data is surprising with its accuracy. You don’t want to embrace it too much all the time but when it starts telling you things and you can start to see behavior through it, it’s fascinating.

Jim – February’s issuance was approximately $21 billion. What’s the outlook for March regarding primary activity and is the distribution of new issues apt to be easy or difficult?

Tom – Already out of the shoot we’ve seen the new issues have had a lot of trouble. Yesterday one of the New York City deals was re-priced and their 10-year maturity 33 basis points cheaper than the retail order period the day before. There was another loan which right now just escapes me, but it was re-priced 11 basis points weaker also in the 10-year maturity. The indication here is there’s going to be a considerable amount of struggle. The retail investor, who is dominant in the consumption of muni bonds, is critical to the distribution right now, is really distracted by the losses that are occurring in the equity markets. Tax time is now on everyone’s mind. Either they’re concerned they don’t have the money or they’re trying to find it. To that point we’ve seen tax-exempt money funds have lost assets I think continuously since the middle of January. So this is evidence that certainly investors are looking for more yield and some of them have gone into muni bond funds to some degree but they’re also taking cash out in preparation of tax bills that some of them will have. What we do expect, March usually we see municipal issuance increases as compared to February. Usually it’s about 30% if we look at the averages relative comparison of March to February since 1990. Only twice has municipal issuance in March been less than February. What I think we’ll take away from this is we’re all trying gage about just what kind of access municipal issuers will have in 2009. I think March will be very telling for us if we see anything that deviates dramatically from the historical pattern of having more issuance in March than February.

Jim – I noticed that some issuers are moving away from competitive bond sales to negotiated sales. I think Georgia was one of them in February. Is that a trend you think will continue or is that a way to have a better retail distribution? What do you think?

Tom – I think its two things. It is a good point Jim. The institutional book has been very difficult to build, in other words getting the institutional orders. So the success has come from having a two-day order period specifically for retail investors and they have all sorts of measures to define who is an individual, who is retail. There’s been success with that. Again February, not as volatile, but as I was mentioning some days there just wasn’t a bid in the municipal market. There’s inconsistent liquidity. And if you’re an issuer and trying to sell competitively on a day where the market doesn’t have a bid or where it isn’t liquid, it’s going to be very difficult to get people to commit capital. We saw this in October when the market was really strained. That State of Florida had, I think their cover, the third bidder was 20 basis points higher in yield on a total interest cost basis than the winning bid. And so an issuer’s ability to understand the market context that they’re selling bonds in, I think, is becoming very difficult. It’s also becoming very treacherous to rely on the competitive marketplace when you just don’t know who is going to show up. I think we’re going to see more negotiated deals just as you had observed. The retail order period will continue to be a way to distribute the bonds and I think we’ll probably see states and municipalities trying to do all they can to get their name out to individual investors. I think that’s probably a really positive thing to educate and inform people that they’re coming to market and that there’s an opportunity to buy a pretty good investment.

Jim – I know you make use of Barclay’s Municipal Swap Index to measure market demand and pricing dynamics. What was the index telling you about the market at the end of February and could you explain why you’re interested in this index?

Tom – The Barclay’s Index, which was first created when it was the Lehman Municipal Group is it’s a 3,000 bond index that’s used for a swap product that Barclay’s is marketing. I couldn’t tell you whether that is a vibrant product, or successful, I couldn’t tell you anything about that. But I do know is this, in the year and a half or so that the index has been published in the market and it’s available on Bloomberg by typing in LMIS Go, and by the way Barclay’s isn’t a client of MMA so this is free advertising for them. The 3,000 bonds that comprise the index are all evaluated each day by one of the two primary evaluation services, IDC or S&P. What’s important about it is that measuring the degree that the spread disparity of the swap index to our data, our MMA benchmark, is we’re able to see how strong the demand is in the market or how weak it is. We usually focus on the five, ten and the 30-year spot. Coming in in January for example, when yields were extremely low, we saw the Barclay Index showing historical spreads that were reflective of an incredible demand component. A very high risk as we now define the spread as being a risk condition or a value condition and it was a very high risk. It persisted into the middle of February and then coinciding with the change in seasonal patterns, the spread started to tighten and the Barclay Index yield moved from a position of being lower than our MMA data to being a yield that was higher than that. And where we saw the adjustment occur most dramatically was in the five- and ten-year maturity, and specifically the five-year maturity. It hasn’t quite made it all out to the long end yet. So we were seeing at the end of February the adjustment in this index suggested to us that the evaluations of people owning investment grade bonds were now seeing a cheapening occur and that new money really could be encouraged to come in to the front of the yield curve again, an area that at the start of January was excessively rich and we were discouraging investors from going there. Now we’re kind of looking at an increasing opportunity in the front of the marketplace. Probably not a bad place to be as well, given the negative seasonal price bias that we associate with the end of the first quarter and start of the second quarter. So it’s a very interesting piece of data. Again I can’t tell you much about the product, but if I can have a prospective of what the evaluations and what portfolio managers are thinking or what they’re seeing in shaping in terms of value at risk, then that’s a lot easier to have discussions about the market. We have the same discussion with issuers too as to what to sell on the strength and be a little bit hesitant when they issue debt. So, very interesting data.

Jim – California’s GO debt was downgraded from “A+” to “A” but there appeared to be budget resolve. Could California be a template for what we might expect from other states going forward?

Tom– I think the good news there in California was that people are finally able to make some tough decisions. You had an agreement that they increase their sales tax I think is what they ended up deciding and these are all good steps. I think California being the largest of the states, despite the downgrade, taking some really strong steps to get their fiscal house in order. Probably long over due. I think that’s encouraging to other states as to steps they’re going to have to take in this era of great challenges that no one’s willing to share the pain if you will. I think this is very encouraging. We haven’t seen the market necessarily react to it relative to any type of market performance just because the municipal market in general is in such disarray as I was alluding to, this correction that’s been going on for the last ten trading days. It may be a little bit premature in seeing anything real positive coming out from the investors in the way they perceive California, but I think this is good news and I think we’re going to see some other states follow suit and again very positive.

Jim – Finally Tom, MMA has had an increased involvement with individual investors in the lat eight months. What is your sense of investors’ interest in municipals at this point of the year.

Tom – You can’t discount again the distractions of what’s going on in the equity market of keeping people not focused on munis. And they’re just kind of paralyzed about everything. Our impression is probably municipal bonds are going to be the product of 2009. I think the performance we’ve seen year to date as I eluded to earlier, +5, +7%. Certainly there are going to be some credit headlines that are going to emerge in 2009. We probably will see some defaults that are going to be the healthcare industry as we’re probably the most keyed and following and seeing where there’s some stress. But I think overall is that despite ratings downgrades like we saw with California, the headlines that will probably continue to emerge about pensions being under funded and the liabilities that states have, different problems with fees and all of that. I think we’re going still see on a relative basis with what’s happening in the equity market, the challenges happening with corporations with today, Citibank’s stock value being under a dollar, with dividends being cut so dramatically in places like GE, that all of a sudden investors are looking for stability of income and they’re looking for a security that has virtually no default risk in the investment grade sector. Is that I think you’re going to see investors really starting to flock to this product. I think what we’re also going to see is the re-emergence of what used to be considered an antiquated packaged investment product which is has been the unit investment trust (UIT). We’ve already seen three or four institutions that are assembling groups of bonds that won’t be managed, but they’re just grouped together, to offer investors an attractive yield. We’ve seen a foreign entity that is looking to create a equity/income type product and they’re combining municipals with equities. I think these are all good signs of demand. I think it will be helpful to the market going forward, but in the near term everybody’s distracted but I think the history of stability and the opportunity of getting income is, that despite the low absolute yields, is that I think individual investors are going to still maintain their interest in the product. It should be a very busy year for everybody involved.

Jim – Thanks Tom.

Tom – Jim always a pleasure. Look forward to talking to you next time.