Municipal Bond Market Update - February 22

MARKET UPDATE

The primary market is returning rapidly, putting some upward pressure on yields.

RECOMMENDATION

Last week’s rising yields have slowed positive momentum; however, near-term performance trends are still encouraging among shorter-intermediates. The long end of the curve continues to look attractive from a relative performance perspective, and stretching for yield here may not carry the potential risks of late 2009. The front of the curve remains extremely well bid because of intense demand from money funds and the accounts who hope to sell them bonds. Any potential rate increase would affect bonds here most directly but structural scarcity also implies strong outperformance of taxables.

INVESTING STRATEGY

Moody’s will be announcing its plans for reconciling the municipal and global rating scales by the end of next month. This will likely mean upgrades for many sub-AA safe sector bonds, helping related performance on both better investor demand and worsening tax-exempt scarcity (as more bonds get BAB friendly ratings).

SUMMARY

With the Fed beginning what will likely be a slow road back to more normal intervention in the economy, Treasuries took a beating last week and municipal bonds saw sympathetic, if modest, losses across the yield curve. Still, this meant strong outperformance by tax-exempt paper that, with tax rates likely to go up and BAB-related scarcity likely to worsen or at least persist, may be setting the stage for record richness in tax-exempts over the next year. If the Fed’s actions continue to cheapen up earlier Treasury maturities, municipals could also see at least a modest wave of advance refunding supply—giving accounts yet another reason to bid for higher coupon, higher rated paper. Finally, the Fed’s actions may begin the long awaited period of rising rates, creating a very positive environment for the re-emergence of leveraged, arbitrage-oriented investors in the municipal space. That is, assuming systemic municipal bondholder security holds together even as budget and policy conditions continue to worsen. We note three new lines in our default database, showing that, although $5.3Bn of municipals have announced some form of payment default, only $1.0Bn of these were initially rated investment grade. We also detail the experience of Orange County, CA bondholders in what still is the largest ever municipal bankruptcy. Throughout the county’s experience, the only bond payment default that lasted more than a few days was related to a failed tender of $110MM pension bonds, and all holders ultimately received par.