Municipal Bonds Gain - California Munis Could Look Attractive Soon - Regulatory Reform Moves Forward

MARKET UPDATE

Although yields are low, leading edge support has been thin, at least until June reinvestment begins.

RECOMMENDATION

The front of the yield curve remains solidly positioned to, at worst, maintain absolute and relative value although the lack of income is dissuading to investors with calculators. With relative value reading substantially “cheap”, longer bond investors are likely better situated to trade for relative performance via hedged portfolios or straight up arbitrage trades; however, flights to safety in the past two years have usually been stronger and longer than expected, so great care is advised on timing. We believe issuers should be in the market, even though instantaneous disruptions this week could drive cuts or drag out selling periods; yields are that low.

INVESTING STRATEGY

California’s budget debate looks to be difficult, with Democrats having a major issue with the enormous cuts proposed by the Governor; look for more gimmickry and the potential for rating warnings and downgrades. This may provide an opportunity for accounts looking to get back into that market.

SUMMARY

Municipal bonds had an excellent week last week as, despite the flight to safety in Treasuries, broad-based “de-risking” in some asset classes, and more rhetoric about just how bad municipal issuers are (the latest, “Municipals The Next Financial Land Mine?”), muni yields trickled lower. Of course, this meant dramatic underperformance versus Treasuries and LIBOR, damaging the return of hedged portfolios and dramatically increasing issuers’ cost of terminating outstanding swaps. We don’t believe that the tax-exempt market has the capability to rally on pace with taxables—nominal yields are already too low despite scarcity of tax-exempt paper. Further, with the June reinvestment demand surge now imminent, our market may stay harnessed very much to where yields are right now, regardless of what goes on in taxables. Importantly, last week the regulatory reform debate took a huge step forward with passage of the Senate proposal and the start of reconciliation. In theory, the Government would like to conclude the process by July 4th, but we recommend on betting in favor of “looser” standards now that the House of Representatives gets another shot at things. Also last week, Congress formally proposed extending the BAB program another two years but at lower subsidy rates. These—along with some issuer discontent over subsidy offsets and potentially wider corporate credit spreads—may trim future issuance, but, because BABs are already close to breaking even with tax-exempts, a year-end surge of paper remains unlikely on the merits.