The municipal bond market is completing the halfway point of 2012 with a number of themes similar to those that were playing out last fall.
Very cheap ratios in the intermediate and long end of the market
The ten- and thirty-year MMA (Municipal Market Advisors) yields moved from 2.41% to 2.12% on the ten-year level and from 4.34% to 4.14% on the thirty-year level. Compare this to the much more dramatic downward movement in US Treasury yields, where the ten-year moved from 2.30% to 1.60% and the thirty-year from 3.44% to 2.70%. This means that the ten-year MMA/Treasury ratio went from 104.7% to 132.5%, and the thirty-year ratio went from 126.1% to 153%. This has effectively erased the lowering of ratios that we saw in the first quarter and put municipal bonds’ relative cheapness back to the same levels as last fall, and cheaper than where they finished 2011. This clearly has been caused by the severe drop in Treasury yields due to continued concerns about Greece and Spain in particular and the European Union in general. As we have written in other pieces, the relative value of municipals is such that, at these ratio levels, an eventual rise in Treasury yields due to an improvement in the overall global economy COMBINED with a return to TRADITIONAL ratios (85% in the ten-year range, 90% in the thirty-year range) should result in very good relative performance from municipals – in other words, the defensiveness of today’s issues is built into the cheap relative prices.
The new-issue calendar for this year is running 12.6% ahead of last year’s calendar. You may remember that last year’s new-issues calendar was approximately $300 billion vs. $400 billion in 2010. Last year’s drop was due to a combination of factors: issuers’ reluctance to issue bonds early in the year during the high yields of the Whitney/bond-fund outflows, overall higher municipal austerity, and the fact that some issuance had been moved up to 2010 after the mid-term elections. This year’s RISE in issuance can be deceiving, as a lot of it is issuers refunding older issues on a current basis. These are bonds issued ten years ago whose call provisions are now becoming current. Issuers can replace this debt with new debt having coupons that are 1-1.5% lower than ten years ago. This is a meaningful cost savings for the issuers. Thus, NET new issuance is quite small after the calls are taken into account. However, the Bond Buyer 30-day Visible Supply peaked at $15.4 billion in early June, after averaging $8.1 billion during the first quarter of this year. These bottlenecks of supply can keep yields higher on a relative basis, even as Treasury yields drop. This is the nature of what remains a retail investor-dominated market.
While overall municipal credit continues to improve, the amount of muni “hot spots” continues to grow. This week we saw Stockton, CA opt to file for Chapter 9 bankruptcy. Clearly this is in response to the very high costs the municipality is absorbing from police and fire contracts, and the city hopes this is a route to renegotiating those contracts. The implications of the city’s move include very high financing costs when it emerges from bankruptcy, as well spillover effects to other local California governments that are having similar problems. The Stockton situation points out the attractiveness of essential-service revenue bonds, where a lien is in place against revenues, as opposed to just a pledge to pay. It also demonstrates the need to remain vigilant on credit – especially in a world where there is little bond insurance on new issues. Surveillance has BECOME bond insurance in its purest form. There continues to be a focus on the states of California and Illinois and on cities such as Harrisburg, PA, and Providence, RI. But more cities will come under scrutiny and be exposed to headline risk.
And finally, as we end this quarter, the Supreme Court has effectively upheld the Patient Protection and Affordable Care Act (PPACA). While we are digging into the ramifications of this in the world of municipal hospital and health-care bonds, it would seem to reinforce the tightening of credit spreads in hospital bonds that we have seen over the past year.
Have a great Independence Day!