Monday, January 11, 2010

Update on Municipal Bonds

George Friedlander from Citigroup came out with an interesting piece on municipal bonds today. George has been a muni analyst for a number of years, and is very well-respected.

Here's a summary of some of his thoughts (edited by me in the interest of brevity):

Municipal yields are actually DOWN sharply from the end of 2008. So, in contrast to the yield rebound in Treasuries, AAA muni yields in 5, 10 and 30 years were DOWN 90, 52 and 89 basis points, respectively through year-end.

Reasons for this powerful relative performance fall largely into eight categories:

1. Muni yields had gotten distended on the upside at the end of 2008, as the capital markets collapsed, bond fund flows turned negative, leveraged investors unwound their positions.

2. Investors in all capital market sectors had sought protection from risk in the Treasury market, causing demand in that sector to overwhelm supply. Since then, the supply/demand imbalance has been largely unwound, causing Treasury yields to rise more thans every other major fixed income sector.

3. The collapse in short-term yields has forced investors to seek alternatives. In tax-exempt money market funds, specifically, yields are effectively down to zero.

4. Individual investors still have massive amounts in low-yielding short-term instruments. According to the Federal Reserve Flow of Funds Data, at the end of the third quarter 2008, the "Household Sector" (individuals and non-profits) held roughly $8 trillion in short maturity holdings. Even a continued trickle out of this vast pool of low-yield holdings can provide powerful demand for munis.

5. Flows into tax-exempt bond funds blew through all former record by a massive amount, with totals for 2009 of approximately $77 billion, according to AMG/Lipper. The prior record was $42.9 billion in 1993, so 2009 flows beat the record by roughly 80%.

6. There is no reason to expect that demand from direct buyers of munis will diminish any time soon, either. They, too, hold large amount of short-term instrument with very low yields, and in addition, higher income investors are looking at a substantial increase in maximum marginal tax rates by 2011, when the Bush tax cuts expire. In addition, the need to pay for Health Care reform, assuming it is enacted, could push taxes higher still.

7. There were significant supports for institutional demand for munis in the stimulus package in the form of changes in regulation for banks and property/casualty companies. Essentially these changes make munis even more attractive to these institutions.

8. The issuance of taxable Build America Bonds as a substitute for tax-exempt munis. Issuance of BABs started in April 2009, with large deals for the State of California and the New Jersey Turnpike, among others. For full-year 2009, the Bond Buyer estimates that $64.1 billion of BABs were issued, roughly 15% of total supply, but roughly 20% of supply since April when they first started to be issued.