Municipal Bond Market Commentary
Q1 2009
Municipal bond investors experienced significant change and disruption in 2008
Bond insurance ceased to be a major factor in both the primary and secondary markets. Prior to 2008, nearly 50% of all new issues came to market with insurance. By year-end it was less than 10% as newcomer Berkshire Hathaway was the lone insurer possessing Moody's coveted Aaa rating. Two insurers were rated double-A, but MBIA and AMBAC were barely able to hang on to investment grade ratings. This alone would have changed the scope of the municipal market, but other problems plagued the municipal market too. The Auction Rate Securities and Auction Rate Preferred markets froze leaving many investors with illiquid investments (most with very low yields) and many Variable Rate Demand Notes suffered impaired liquidity. This happened first as a result of declining credit ratings due to their insurance wraps and third party guarantors, then later in the year when remarketing agents were unwilling to hold tendered issues in their troubled inventory.
In the long-end of the municipal market, many traditional buyers such as property and casualty insurers (e.g. AIG) turned into net sellers adding supply to the market. Non-traditional buyers such as municipal hedge funds sold bonds to raise cash and mutual funds unwound tender option bond (TOB) programs that were no longer profitable. The absence of these significant sources of municipal demand initiated three price downdrafts (February, October, and early December). TOB programs totaled a mere $12 billion at year-end versus $120 billion at their high mid-2007.
Risk was re-priced as yield spreads between upper and lower investment grade issuers widened dramatically, with the latter suffering periods of virtual illiquidity. Perhaps most important, the ranks of municipal broker-dealers, a primary source of liquidity in the secondary market, were reduced as several top tier firms (Bear Stearns, UBS, Lehman Brothers, Wachovia, and Merrill Lynch) either ceased to exist or were forced to merge. Towards the end of 2008, the absence of the broker dealers created depressed prices, inefficient markets, and attractive yields in its wake.
The Need for Independent Credit Analysis
Credit quality, especially with insurers virtually out of the picture, will be a predominant concern in 2009 and independent analysis of an issuer's financial strength will be essential. Increasing budget deficits and, as a result, wide credit spreads between lower and higher quality issues are likely to continue. Deteriorating revenues are confronting nearly every state, with sales, personal and corporate income tax revenues shrinking as consumer confidence plunges, unemployment rises, and business continues to decline. Based on data from the Center on Budget and Policy Priorities, 45 states are facing shortfalls in their budgets, which are expected to extend into 2010. The shortages are especially acute in California, Arizona, and Nevada due to unsuccessful real estate speculation. New York is facing similar stress due to its economic dependence on the financial sector. Underlying entities within each state (e.g. as cities, counties, school districts, and public universities), which are reliant on state appropriations, are also expected to feel the impact of these budget imbalances through reduced state aid. All but the most affluent cities have additional concerns due to serious declines in property taxes.
Supply and the proposed changes by the U S Government
Despite the current credit concerns, municipals remain attractive for investors looking for high quality bond investments. In 2009, supply and demand will be impacted by a number of factors. New issue volume is expected to contract from 2008 totals, which was inflated by the mid-year refinancing of Auction Rate Securities. Nonetheless, the recently unveiled American Recovery and Reinvestment Plan (ARRP), as currently proposed, authorizes the issuance of municipal bonds for various purposes while also providing aid to states and municipalities for infrastructure, water projects and airport improvement grants. ARRP further exempts all new issue private activity bonds from the alternative minimum tax (AMT) for 2009 and 2010, which should increase their issuance while improving their marketability and demand. In addition, it allows banks to deduct 80% of the carrying costs for bonds of states, counties and local governments that issue up to $30 million annually (up from $10 million), thereby making banks a source of demand for smaller issuers. Moreover, the need by many states to finance a portion of their deficits (much of which historically has been done in the short term note market), and the potential for more refinancing by high grade issuers (should rates stay at current levels) will all impact the volume of issuance throughout 2009.
Where do we go from here?
With a very steep yield curve and money market rates at historic lows (under 1%), investors began 2009 with incentives to invest money further out the yield curve. The January reinvestment demand, combined with expectations of assistance to states and municipalities from TARP and the ARRP, has driven market rates lower than most market participants predicted. As was the case in the latter part of 2007, retail investors will likely remain the predominant buyer of municipal bonds into 2009. In the continued absence of demand from property casualty insurers, hedge funds, and mutual funds, we believe a reversion to higher yields is to be expected and ongoing volatility is all but guaranteed. Liquidity will likely be inconsistent and dependent on market supply. Finally, headline risk is high as states and cities struggle to close deficits which should keep credits spread wide.
We are currently cautious on the municipal market and expect rates to increase from their mid-January lows. The new issue calendar will be building and reinvestment demand from calls and maturities is not sufficient to meet the supply that is expected this spring. We continue to recommend that investors be patient and primarily allocate funds to short maturities until demand proves sustainable. Long maturity purchases should be opportunistic and investors should focus on high-quality marketable and analyzed bonds, with an emphasis on essential purpose revenue and dedicated tax issues.