Monday, February 22, 2010

Municipal Market Update

This is a little more of a "bond geeky" post, so if the thought of municipal bonds makes you yawn, please feel free to ignore this note.

Just as in the taxable bond market, the slope of the yield curve (i.e., the difference in yields between shorter maturities and longer maturities) remains steep. However, unlike the taxable market, the most "expensive" part of the yield curve can be found in the 5 year maturity range.

This week's municipal bond research piece from Citigroup dated February 19, 2010 talks about the relative values that can be found in the municipal area.

The reason I have attached it is twofold. First, in my opinion, Citi produces first-rate muni research. And, second, they tend look at the market the way that I was trained to do; namely, comparing the relative yield of municipals versus Treasury yields. While I realize there are numerous other ways to analyze muni bonds, for me simplicity usually wins out.

Here's the excerpt:

The yield curve in the muni market steepened modestly this week, with long-term yields up modestly while the intermediate sector held firm. With Treasury yields edging somewhat higher, high-grade muni yields as a percentage of Treasury yields continued to drop. This is particularly the case in the shorter intermediate range, where high-grade yields appear to be unsustainably low and unattractive.

5-year triple-A munis as a percentage of Treasury yields, for example, are currently at 61.7% -- break-even versus Treasuries for investors in the 38.3% marginal Federal tax bracket. In our view, this is the least attractive point on the muni curve: the ratio versus Treasuries is 71.4% on one-year paper, and 76.1% on 10-year paper.

While ratios on longer maturities are by no means high by historical standards, this is consistent with our thesis for the past several months: supply/demand conditions are likely to push muni yields as a percentage of Treasury yields very close to all-time historical lows, all along the yield curve.

The problem in the 3-5 year range, in particular, is that they are already at or near these lows. As we noted last week, the slope of the muni yield curve remains quite steep in the 5-10-year range, with 10-year AAA paper yielding 148 basis points more than 5-year issues.

The reasons for the low yield ratio in the 3-5-year range, in particular, are not difficult to discern:
  • New issue supply in that range tends to be relatively modest;
  • A historical source of supply in that range, advanced refundings which create pre-refunded paper, have been relatively slow;
There continues to be a virtual avalanche of investible funds leaving low-yielding cash/near cash, seeking a home that is not too risky, and not too far out on the yield curve. An obvious "home" for a significant portion of this cash is shorter maturity high-grade munis, and there simply isn't enough paper to go around without pushing yields down to unattractive levels.