DerivActiv MuniMarket Pulse Podcast - Friday, March 20, 2009

Matt Fabian, Managing Director of Municipal Market Advisors, talks about how the muni market will handle the anticipated supply of large issues. Also; Federal intervention is not necessarily a good thing for the market. (7 m 40 s)

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Episode Transcript

Cynthia – This is Cynthia Heneage standing in for Jim Towne. Matt, welcome, when we spoke last week you talked about the muni market being stuck in a range. Is that still the case?

Matt – I think in a sense it is. The muni market has a difficult time rallying because there is real rejection of too low absolute yields by the individual investors who are supporting the market, who are really the prime buyers of tax-exempt bonds right now. But at the same time institutional demand has been weak, but there’s enough support just behind these levels that we’ve seen, so that once yields rise, enough demand comes in there to sort-of mitigate the losses. So we have been stuck in a range over the last few weeks. What that has done is because there’s no firm, positive trend in prices and that positive trend is really important for investors and underwriters who are making commitments in the primary market. Without the firm, positive trend, underwriters have had to take a very cautious stance in bringing new bonds to market. So when they do bring them to market, they price them very cheaply because they don’t necessarily want to be stuck with unsold bond proceeds. So as the market itself tries to consolidate at these higher yields, tries to galvanize demand, another new primary market sale will come in and sort of wash out the base that they had built. We’re in a cycle where the market appears to be in a bit of a rut.

Cynthia – So what’s the outlook for new issuance? Are there any new deals coming on the market?

Matt – Well that’s the pressure this week for sure. This week marks the start of maybe a new phase in the muni market. As of today you’re seeing the initial pricing of a $1 to $2 billion Wisconsin loan. These are bonds backed by the appropriation security of the state of Wisconsin, an exceptionally strong security, except the bonds are being sold to refinance Wisconsin’s outstanding tobacco loan, which has a generally very poor reception among investors. So you have this stigma from the tobacco connection. You also have a problem with the deal size. This is by far the largest issue that the market has seen so far this year and it appears, at least initially, that very strong price concessions are being required to move it. So bonds are being now sold with almost 5% yields at the 10-year which really approximates the kinds of yields that were available last fall when people in the market were touting munis, and so extremely cheap. We’re getting right back to where we were in the fourth quarter. Similarly next week we have a $4 billion bond issue by the State of California and the Commonwealth of Puerto Rico at some point in the near term is going to be bringing another multi-billion loan. There’s an awful lot of supply coming and the market isn’t quite built right now to handle that level of supply. It could be that yields are going to be pushed higher in the near term.

Cynthia – What’s happening in the DC front? Are there any new developments coming out of Washington?

Matt – Last week the markets focus was really riveted because you had the House Essential Services Committee apparently has approved potential legislation. The Committee hasn’t approved it, they intend to introduce legislation that would guarantee all new municipal general obligation bonds with the Treasury. It would provide some kind of reinsurance for all other municipal bonds so long as they’re guaranteed by a bond insurer. And also provide some sort of a backstop to the municipal short-term market. So this is very wide ranging, extremely important for the municipal market. Interestingly the municipal cash market, that’s sort of the bond market, didn’t really react that much, the market itself. The municipal swap market, the credit default swap market, rallied almost 10% over the last two days. So there’s been a real effect from that potential Barney Frank legislation. The implications are unclear. Likely if this bill were to gain traction you would see a very good rally in municipal prices. I don’t think that the municipal market needs federal guarantees of its general obligation securities. There’s actually a bit of a consensus growing it seems on the municipal buy side saying issuers right now maybe don’t have the best market access because they shouldn’t have the best market access and that this is sort of an active intervention to keep them away from issuing more bonds. That really artificial market access or sort of the increasing market access through federal intervention creates a real moral hazard. You may have issuers begin to borrow far more bonds than they should as far as their long-term health. But it is a question and it’s going to be hotly debated in the market if this actually manifests as legislation. Something to be watched very, very closely by the market and by all interested municipal investors.

Cynthia – So does this proposed legislation show that Washington is lacking confidence in the municipal market generally? Is that the case?

Matt – It sure seems like it. You have to remember that in Washington the lobbying pressure from the industry in general is diffuse. So there’s no strong, clear voice from the investors or from the dealers. Really the politicians in Washington hear the issuers, the state and local issuers the most. For many state and local issuers fundamentally they don’t realize why yields were so low between 2002 and 2006. They don’t realize why they have risen and they’re just waiting for them to go back. In effect they’re asking Washington to replace the demand from leveraged buyers, like tender option bond programs, just expecting that that is going to fix everything. The market is fundamentally changed. It’s become a more difficult place for issuers generally. Those sort-of expectations are probably going to be short-lived. But that’s what been driving policy in Washington is the sense that from the issuer’s perspective, because they can’t sell bonds like they used to in the era of leverage, that something’s broken and it needs to be fixed by Washington. I’m just not so sure that that’s the case

Cynthia –Finally Matt, if I’m a muni investor, where would I look for opportunities right now?

Matt –You don’t need to rush. I think if you’re looking to buy bonds for total return, looking at for capital gains, I think munis are dangerous generally. Because you really have unpredictable prices over the next three to six months. If you’re an income-oriented investor and you’re looking for just to buy a nice, safe stream of income, there are definitely opportunities available, but you don’t have to rush because we think that yields are probably going to be rising over the near term. But you need to look in state, out of state. You need to look for unrated bonds, safe sector bonds. Safe sector being unrated general obligation, things in Michigan, City of Detroit, local school districts around Detroit, extremely safe from a fundamental structure perspective but facing a real headwind in the market as far as market perception, very thin demand for those bonds. So it’s a great a great time for an individual investor to go in and buy some Detroit bonds. If you’re looking for liquidity, so something that you might be able to sell at something close to what you paid for it, still pre-refunded bonds which are bonds backed by portfolios of irrevocable escrows of Treasury securities. They are still the prime security. Not only are these bonds backed by portfolios of Treasuries themselves, but from a scarcity perspective because there are fewer and fewer of them being created. Actually the universe of pre-refunded bonds has shrank by 17% over the last year when the number of outstanding total muni bonds has increased by 6%. So you have a scarcity issue also driving the value in liquidity in the pre-refunded sector. I think not necessarily a great yield opportunity because yields are pretty low, but as far as maintaining asset value, maintaining liquidity, I don’t think that you can beat that opportunity in the muni sector right now.