Winners and losers in a hot municipal market

May 22, 2012

Like U.S. Treasury debt, muniland securities have been hot, hot, hot. Investors have been piling into municipal bonds for about 16 consecutive months. At first, demand was driven by investors who were attracted to the high yields in the wake of Meredith Whitney’s predictions of default, which scared retail investors out of the market between November 2010 and February 2011. Demand then accelerated as the Federal Reserve kept interest rates at artificially low levels, driving investors out of Treasuries and into riskier assets. Steady municipal bond mutual-fund flows, coupled with the reinvestment of muniland proceeds into new bond issues, has also helped keep demand elevated.

On the supply side, municipal bond issuance in 2011 slowed to $295 billion, down 32 percent from 2010 and the lowest level since 2001. This lack of supply, along with massive demand, has covered over a lot of issuer weaknesses that would normally drive yields higher. Bloomberg reports:

“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.

One of the beneficiaries of this dynamic has been California. Its bonds have been enjoying strong demand even as the governor announced larger-than-expected deficits last week. Bloomberg said:

The extra yield on issues from California, the lowest-rated U.S. state by Standard & Poor’s, fell to 0.82 percentage point [82 basis points] last week, matching the smallest since December 2008, according to data compiled by Bloomberg.

Although the market has tremendous momentum, some issuers are being left out. For instance, investors are wary of Illinois debt, which has averaged 160 basis points over the last year. Another one of the laggards is Puerto Rico. As seen in the chart below prepared by Daniel Berger of Thomson Reuters MMD, the spread of Puerto Rico’s debt over the MMD AAA benchmark has remained relatively flat over the last year, hovering around an average of 219 basis points.

Puerto Rico has been a big issuer of debt in the past year, so to control for whether oversupply was to blame, Berger compared its performance with that of hospital debt, which also saw heavy issuance (about 9 percent of new municipal debt in 2011 was issued by hospitals). As you can see, hospital debt has ridden the market momentum and, unlike Puerto Rico’s debt, seen its spread over the MMD AAA benchmark decline.

Hot markets generally benefit everyone, but it’s not uncommon for some to be left out. The most interesting question, of course, is what happens to these issuers when the market weakens.


Barron’s: BofA Worries about Muni ‘Rate Shock’ as Issuance Rises

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