Municipal Bond Market Update - May 3, 2010

MARKET UPDATE

A selloff last week has given more yield for retail buyers.

RECOMMENDATION

The municipal yield curve continues to look somewhat rich for most maturities beyond the 9yr; prospective buyers should solicit incremental spread to insulate against medium-term price reversals. And despite fairly persistent gains throughout April, the front of the curve is more neutrally balanced. Additional increases in the 7-day rate may pressure front end prices lower, yields higher, but moves are likely to be minimal so long as high grade paper remains in short supply for the income buyers willing to pay for it.

INVESTING STRATEGY

Financial regulation reform should have only a modest impact on the municipal market, assuming some provisions in the derivatives-specific language is either altered or favorably interpreted for municipal issuers. In any event, these rules imply that municipal derivatives will be more onerous and less profitable for dealers going forward, implying fewer derivatives and less VRDO issuance going forward.

SUMMARY

A slow new issue calendar, uncertainty over whether or not municipals are at risk from a “sovereign contagion”, low nominal yields, underperformance versus Treasuries, more muted fund flows, tighter evaluated credit spreads, and tax-related selling have undermined confidence in municipal prices recently. This has made dealers more reluctant to bring new loans and buyers more hesitant to buy them at current levels. However, a new month should bolster demand as more accounts put coupon and principal payments back into the market, and, if the bailout of Greece actually occurs, tax-exempts are likely to see near-term outperformance of Treasuries. This week there is a larger new issue calendar but also a heavy slate of international and economic developments. The headline issue is California’s refinance of $2Bn Department of Water Resources deficit bonds. This will be a shorter issue and, with high ratings, should fare well in attracting retail demand. Elsewhere, defaults and credit impairment notices have continued, but with only a trickle of new issuers notifying bondholders of trouble in the last few weeks. There remain about $5.7Bn of outstanding munis affected by a payment default, with concentrations in land-dependent financings within mostly smaller, non-rated bonds. So far in the recession, holders of safe sector paper have had little to fear as far as default risk, although we expect incidence of problems will increase for these bonds.