The tax-free bond market has been hit with a spike in long-maturity yields, bringing yields to their highest level of the year. Long-maturity tax-free yields have risen 40-50 basis points and many longer high-quality bonds are now yielding more than 5%. And this has all happened in less than two weeks. How did it happen?
In a perfect storm of events, long tax-free bond yields have been pushed higher by three factors:
1) Higher long-term Treasury yields. The thirty-year US Treasury bond moved from 3.98% to 4.40% yesterday (November 15th). Most of this was related to the Federal Reserve’s plan for Quantitative Easing and the proposed makeup of the Fed buying. Most purchases would be in the intermediate area and not in the long maturities. Since then, long Treasury yields have skyrocketed and long tax-free yields have followed along.
2) Build America Bonds (BABs) have NOT been authorized beyond year-end. There has been a Senate proposal to extend BABs authorization through the end of 2011, albeit with a lower subsidy rate of 32% instead of the current 35%. If the lame duck session of Congress does not pass extension, this will have to wait to be addressed by the new Congress, which may or may not pass extension. The newly elected Republican majority in the House of Representatives lowers the odds of BABs extension, in the eyes of the market. Thus, BABs supply has increased greatly as issuers try to beat the year-end deadline. Higher BABs yields means LESS downward pressure on tax-free yields since the after-subsidy cost (yield) for BABs issuers is lower than for tax-free yields.
3) Higher tax-free supply. Tax-free issuers who have issues that are not BABs-eligible (refunding bonds, general-purpose bonds) have moved up their issuance to the present instead of first quarter 2011. Their reasoning is that without BABS there will be a big shift back to tax-exempt supply; therefore, they are moving up their issues. The effect has been self-fulfilling, as the supply has overwhelmed the market, forcing yields higher. The chart below shows tax-free visible supply, which was trending downward the entire year up to the last two months – it has been clearly affected by the BABs effect.
There are four reasons why we think this is a terrific opportunity:
1) This has not been credit-driven. This is long-maturity bonds following Treasury yields higher, and driven by the confluence of uncertainty regarding BABs legislation and the resulting supply bulge. This is not inflation-driven. Twelve-month trailing inflation is 1.1%.
2) In a world where a thirty-year Treasury is 4.35 to 4.40%, a long, high-quality tax-free bond yielding 5% is a taxable-equivalent yield of almost 7.7%. It is much higher when state taxes are also figured in. And many high-quality issues are trading cheaper than 5%.
3) The normal December and January demand from reinvestment and maturing and called bonds could be in the $35-40 billion area. That is in front of us. A lot of first-quarter supply is being pushed into this quarter. That will be behind us. And there is certainly a chance that Congress does extend BABs, albeit at a lower subsidy rate.
4) If longer Treasury yields continue to climb and tax-free yields eventually return to some degree of normalcy versus Treasuries (as happened in April of this year), there is the chance for many 5.50 to 6.50% coupons to be prerefunded by their issuers. Cushion bonds have been beat up in this market, as well, and offer very compelling values. We believe this is the best opportunity in over a year for long maturity tax-free bonds, and are acting accordingly.
In summary, this is the cheapest that tax-free bonds have been in over a year. This is driven by factors that are unrelated to normal bond market movements such as inflation, employment, etc. We believe this is the best opportunity in over a year and are acting accordingly.