Monday, March 15, 2010

Municipal Market Update

This post is an excerpt from a research piece published by George Friedlander of Morgan Stanley Smith Barney dated March 12, 2010.

It highlights the relative unattractive valuation of the shorter area of the municipal bond market.

Holding firm, but possibly ready to get even firmer

The municipal bond market held firm as Treasury yields edged slightly higher since the middle of the prior week. Yields in the already richly priced 5-year maturity range continued to drop slightly, pushing triple-A 5-year yields, as a percentage of Treasury yields, to within a hairsbreadth of their all-time historical lows, at 59.9%.

That means, an investor would have to expect to be in the 40.1% Federal tax bracket over the 5-year holding period for these munis to yield more after-tax than the Treasuries.

The muni yield curve continues to be extremely steep, particularly in the 5 to 10-year range, with 10-year triple-A paper yielding almost exactly twice as much as 5-year issues, at 2.80% vs. 1.42%.

In our view, a substantial amount of individual investors’ investible funds is "stuck" in shorter intermediate munis, despite yield relationships versus Treasuries that don’t make sense.

Even more than the 5-year maturity, the 3-year muni is a case in point, with yields scraping 51.3% of Treasury yields: Breakeven could only occur in the nonexistent 48.7% tax bracket.

Even double-A 3-year paper yields only 59.3% as much as Treasuries, essentially pointless for any individual or corporate tax bracket.

So, what is going on? To us, it seems that many holders of the massive amount of cash yielding close to zero:

• remain within the confines of a high-grade muni portfolio
• are unwilling to extend maturity, and
• are simply waiting until muni yields normalize.

A portion of this demand pressure on the short end, of course, comes from the collapse in holdings of tax-exempt money market funds, down $93 billion in assets in 2009, according to the Federal Reserve Flow of Funds, and down $17 billion so far this year, per Lipper/AMG flow data.