Municipal Bond Update - 2000 May Be Good Roadmap for Direction of Muni Market

July 7, 2010

Interviewees: Tom Doe, Founder and CEO of Municipal Market Advisors

• Interviewer: Jim Towne, Senior Vice President at DerivActiv, LLC

• Duration: 13 minutes 12 seconds

Available for download at www.mma-research.com

Episode Transcript:

Jim – Tom, nice to have you on the call today.

Tom – Hey Jim, great to talk to you and a belated Happy July 4th.

Jim – The month began with Warren Buffet stating he expected a terrible problem in the municipal market. What was the impact from the “Oracle of Omaha’s” comments on the municipal bond market in June?

Tom – Well he continues to exert his influence in every market on which he talks or comments on and municipals couldn’t escape it. And certainly at the beginning of June some of Buffet’s remarks, as well as those of other media sources, contributed to higher yields and the municipal market losing its positive tone as June progressed. After a while, as yields backed-up, investors did return to the municipal market fairly aggressively, particularly in the intermediate portion of the yield curve, 5 to 10 years, where most individual investors where participating, where we saw mutual funds who still had positive inflows participating, and even an occasional property and casualty company coming in. So there still remained pretty good demand for the supply that was issued. It was of note, just because the credit headlines that have been so pervasive in 2010 around the state pensions, and the possibility of a default, or at least a bankruptcy, of a major credit name, is that when you look at the performance of the mutual funds using the Lipper Indices, is that still investors have not exited the funds where there have been the negative credit headlines. So troubled states or states that have been in the headlines such as Arizona, like Colorado, New Jersey, New York, where the pension story has been so prominent, those funds are among the top performers among state funds and high yield remains the top performing sector of the municipal market. So for the income investor and someone who’s not concerned about fluctuation of the NAV, those higher coupons, those higher interest payments, are certainly beneficial and so we haven’t seen the retail investor flee the market just yet. The positive things [of] all these comments by people like Buffet, is that it’s raising the awareness and we’re seeing action being taken by some of the states and making some of the difficult choices that have been put off for some time. All-in-all probably a good thing for the marketplace, but the bottom line still is relatively light supply and steady demand.

Jim – Tom, you noted that tax-exempt issuance in June was extraordinarily low. Was there more to it than BAB issuance impacting the calendar?

Tom – I think it was Jim, and I think, again come back to these headlines and all the pressure that’s being asserted on politicians to be very sensitive to their issuance of debt and of expanding their deficits. Total municipal issuance, both tax-exempt and taxable, was about $30 billion in June, very light month. The last few years we’ve been over $40 billion, some of that of course in the past has been associated with some of the fixing out of short-term debt, of variable rate debt, auction rates, and this type of thing, so $30 billion very low. But even more extraordinarily was the $20 billion of tax-exempt issuance, and again this ties back to my earlier comment of light supply and strong demand. That $20 billion figure is the lowest we’ve seen for the month of June since 1997. That’s the type of a pace of issuance that harkens back to a different era when the traditional investor was the dominant demand component, and that’s exactly what we have now. So when we’re looking actually at overall performance of the market or try to look at seasonals or how the market might behave, we’re really focusing a lot as a firm on the late 1990s period because we think that the dynamics of supply-demand are now much more consistent with that type of composition of smaller deals, more of a balance between traditional investor and fairly small dealer activity.

BABs issued almost $10 billion, it was fairly significant, one of the larger months we’ve had, still skewed toward the longer half of the yield curve. We also saw some of the BAB issuance exerting a force on tax-exempts in terms of some of the pricing. So it’s not all BABs, but certainly an influence still.

Jim –Speaking of BABs, it appeared that pricing of the taxable loans was credit specific. Was BAB pricing telling us more about the municipal credits than the tax-exempt sector?

Tom – I think the BAB pricing has been a little bit more sensitive to investor demand and investor concerns around the headlines. It was very noticeable, there was a Massachusetts, I think it was a water pollution deal, that was about 125 basis points over the Treasury benchmark, and that was a “AAA” credit, a state revolving fund. The Illinois GOs that were priced, competitively bid, a 35 basis point cover, which of course is huge and reflects a weakness of interest. It was 300 basis points nearly over the Treasury benchmark, a very wide spread that’s kind of like back when we were seeing California issue when the BAB program began. And again Illinois has been very prominent in the negative headlines around their state pension issues. I think what we’re seeing is with the taxable investor not being entirely comfortable with the municipal credits, not fully understanding the subtleties or the distinctions between default and bankruptcy, is that they’re displaying a little bit more price sensitivity and probably telling us a little bit more about the risks that investors are feeling around the credits.

Jim – The fundamental data was reported in June near expectations, though the non-farm data did reflect the census impact. Tom, you seem to see the non-farm data in an important historical context, can you explain?

Tom – Yes, all the fundamental data was just about on the mark, especially when you’re just focusing on the inflation pieces, CPI (Consumer Price Index), PPI (Producer Price Index), PCE (Personal Consumption Expenditure) Core, all reflected benign conditions that of course led to the FMC deciding not to raise interest rates and keeping their extended period language in regarding how long they’re going to keep the funds rate low. What was interesting about the non-farm data, of course in June that was the May report that was released and the non-farm number was exceptionally high. It was exceptionally high because of the influence of census workers hired by the government. In 2000 was the last time we had a census and we had similar types of high expectations, high estimates for what the non-farm data would be when it was released in June. Interestingly enough, 2000 was also a weak period for the US economy or at least there was certainly a great deal of ambiguity. In 2000, municipals and Treasuries rallied fairly significantly, albeit from much higher absolute levels, but I think that you get so much ambiguity around this non-farm data, it’s hard to read the employment reports during the summer months as the census data is adjusted for in the numbers. People start looking at private payrolls. What it could mean is that if we still have all these concerns around the EU, and we still have low inflation and we still have a passive Fed, is that you could see interest rates, even though they’re extraordinarily low, even move a little bit lower as the month progresses. So I think it’s important to look back at 2000, it may not be an exact roadmap but probably gives you an underlying tone.

Jim – Municipals to Treasury ratios remained exceptionally high. Is this helping the municipal market?

Tom – The ratios are back, at least for our data that we produce here on munis. Our muni benchmark is over 100% again—munis relative to Treasuries—which would just argue that this is a wonderful time to be buying munis on a relative basis. Of course the issue here is that we’re not seeing a lot of relative buyers coming into the municipal market, which in the past had predominately been the insurance companies. While they’re present, they’re not the same force as they have been in the past. I think the real thing is the high ratios are making people cautious about interest rates in general because normally when you have a high ratio it means the Treasuries have rallied exceptionally. And that’s of course what happened in June, the whole flight to safety regarding the EU. I think it’s helped, it makes that cheap argument attractive or compelling to some investors, but at the end of the day you still have the high-grade 10-year municipal yield under 3% and you’ve got Treasury 10-years under 3%, and unless you really have a very pessimistic and dour outlook on the US economy and global economy, which of course is easy to create, you’re probably a little bit hesitate putting cash to work, and that may just be what we’re seeing.

Jim – Finally, July has a positive historical bias according to MMA. What does the month ahead look like?

Tom – The seasonal bias, we’ve talked about this in the past when we’ve spoken, is that it’s really following these traditional patterns that we saw in the 1990s when the reinvestment flows were important, when the amount of primary supply was an important factor, when the flows in and out of the mutual funds was important in telling market direction. And the May rally that we saw followed seasonal expectations, the June correction at the start of the month was consistent with expectations, the rally at the end of June was exactly what we've seen over the last few years. The one exception we had with the June ending rally was, in I believe it was 2006, when we had a property and casualty company liquidate about $7 to 8 billion amid $45 billion in primary issuance. That’s the kind of thing that hurts the market. So in July, normally what we’ve seen is the municipal calendar is very, very light. This week that we’re talking here, the first week of July, is less than $3 billion being issued and a chunk of that is BABs. We still have over $40 billion in municipal reinvestment. Light calendar, tremendous imbalance and we’re seeing municipals being valued strongly on this imbalance of supply-demand. It usually continues until mid-July and then the market plateaus. Historically it hasn’t sold off in July. It’s traditionally held, and in fact since 1990, so that’s 20-some-odd years, the only time that the municipal market has lost more than 1% during the month of July was in 2003 and in 2005. And 2003 was after we’d had the June deflation rally. I will just add as a side note that our current tax-exempt yield measures are back toward where they were in June 2003. And in some cases the super high-grades, like the Wake County, North Carolinas or the Marylands, those yields are actually even lower that what we saw in June of 2003. So, as I said, probably the market holds together if we’re like 2000, it maintains this positive bias. We think issuance will continue to be light. Certainly the 100% ratio is suggesting that munis will hold in a little bit better. So if an investor can get through the headlines and really understand municipal credits, and what the risks to them getting their money back are, then munis probably still remain a pretty good place to be in July.

Jim – Thanks Tom, it was great speaking with you.

Tom – Jim, always a pleasure. We’ll talk to you soon.

Information in MMA publications is relied upon by dealers, investors and issuers engaged in the tax-exempt market. You can find more information online at www.mma-research.com