Thursday, March 06, 2008

Municipal Bonds: Yeeeeaaaaahooooooo!

Municipal bond yields are falling fast after hitting record highs versus Treasury bonds on Friday. Late last week, municipal arbitrage funds were being hit with margin calls, as their hedges were rapidly moving against them. This lead to billions of dollars in forced selling, which when pushed on the relatively illiquid municipal market, caused prices to plummet. On Friday, high quality municipals were widely available at spreads of 100bps or more above Treasury rates. Typically municipals yield about 80% of Treasury rates.

Initially word on the street was that these historic levels were enticing hedge funds and other non-traditional muni buyers (even Bill Gross) to buy tax-exempt munis. This was good news and bad news of course. It meant that there was indeed capital in the system to ensure that the muni market would clear. The bad news was that these non-traditional buyers would only be around as long as muni prices were stupid cheap. In other words, this was fast money, and fast money never sparks a persistent rally. Fast money is always looking to take its profit and get out. At best, these non-traditional buyers would merely prevent the muni market from going lower still.

But the initial read was apparently wrong. On Monday, retail buyers (i.e., mom and pop investors) started coming out of the woodwork to buy bonds. The State of California came with a $1.7 billion deal on Monday. Demand was so strong that the underwriter cut the interest rate by 15bps across the board, and still $1 billion of the deal was done retail. Now maybe there has been $1 billion of a deal done retail in the past, but I sure as hell don't remember ever hearing of such a thing. Smith Barney, Citigroup's retail brokerage arm, supposedly had the best day for selling municipal bonds in their entire history on Monday. One large dealer I talk to regularly said they had sold every bond in their inventory by 11AM.

Overall, municipal bond rates are probably 15bps lower today than on Friday, while Treasury rates are about 15bps higher. Strong retail demand is critical for improvement in the muni market. First it means that long-term buyers are soaking up the massive supply hitting the market. Second it means that long-term buyers have not lost confidence in municipals amidst the bond insurer problems.

So what happened to the arb fund selling? I've heard that the arb funds had to meet margin calls on Friday, but seem to now have adequate margin to move forward. That being said, we are still seeing selling from arb funds, but its coming in the form of smaller lists of offerings as opposed to bid lists. The difference is the degree of desperation. A bid list means you need cash now, an offering list means you will sell bonds but only if you get your price.

The bottom line is that the muni market looks a lot stronger than I initiall expected.

16 comments:

the muni investor said...

This is very interesting. I see the drop in yields from last week itself (about 20 bps). Your reasoning about the rates sounds very plausible, but I'm still very skeptical about failures in the muni market - especially in California. I do expect to see some failures in the market - just not at catastrophic levels to cause muni investors to loose faith. Do you have additional details on the SB sale - breakdown by the type of bond and location ? Excellent post again. Thanks.

Anonymous said...

Just observing since 03/03/08 to 03/06/08 the Fed drain the liquidity by 11 bil

steve said...

while it sounds great that all the 'smart money' is coming out of the woodworks to buy munis right along with mom and pops, how about NOT getting to overly excited, just yet ... NOT suggesting the sky's falling BUT i'm hardly going to be impressed that Citi Smith Barney had their best day ever and inventories are gone by 11am ... Is Citi not the same shop that's ALSO going to CUT it's mortgage exposure by $45Bil (here's link to CNBC story http://www.cnbc.com/id/23506350 ) ... how long did it take for them to figure out that this was NOT gonna work out to well? Since August? OK ... I'm NOT trying to infer the Muni mkt is going the same way as the mortgage mkt .. it can't. Fed and the politicians in DC will NOT let it. They have essentially been telling us ALL this for about a week now. Bernanke asking banks to take MORE losses and writedowns. Terrific. Sorry for seemingly UNrelated rant and response. HOPE you make boatloads of money on your muni's. Have many friends in same boat BUT when trader/buddy over at very large east coast mmgr suggests to ME that he's been the only one in the pool just about ALL week, well, that's good and it's bad. New supply keeps on building and at some point coming. Mom and pop have only SO much appetite. Yourself and Bill Gross (who just today denied talk that he single handidly bot UBS Alt-A portfolio worth $24Bil) at some point too will be FULL. Unless of course you keep raking in new account cash -- and god willing you all will. Lets just keep our eyes on why we're here in the first place and just because Muni's have gone down aggressively -- that in and of itself doesnt make them cheap. Yep they've snapped back for you. Again, hopefully you all make buckets of money. Hedge Funds aren't the ONLY guys being forced, though, to sell. Thornburg Mortgage last I checked is NOT a hf. Carlyle too -- thought they were only buying AAA stuff (NOT that ratings mean much of anything right now) ...

System, generally speaking -- credit spreads, swaps spreads, Tsies vs Futures (basis), repo, whatever it is you like to watch -- system generally BROKEN today.

It's gotta be fixed. Bernanke COULD do something other than cut FedFunds -- perhaps reserve requirement? Something's gotta give -- Did you note the way mkts reacted to rumor of 100% EX-plicit govt guarantee for GSEs? Not that ITS the answer, but interesting to think about nonetheless. And depressing IF that is what this all comes down to.

Again, apologies for long meaninless rant/response, it's just hard to get excited about muni's that have strung together 3days of a rally. Couple months ago nobody even considered THIS as a possibility. WHAT's next? Student Loans? Credit Cards? TGIF! Good luck thru NFP tomorrow!

Accrued Interest said...

Yeah I don't think you should read a quick turnaround in munis as "everything is OK." I think you read it as "munis are OK." and that's it. I mean, that's good news in that the contagion as it pertains to the muni market MIGHT be checked, but its not like this is a green light for credit in general.

Anonymous said...

Hi,
I'm new to the Muni bond auction market. How do people determine what the bid yield for the muni should be? and what happens at the end of the 7 or 28 day priod? do you bid again for another 7 or 28 days at a different level? or do you just get your money back at par and that's it? and is there a perception that revenue bonds are less secure?

Anonymous said...

One think ANNOYING thing about Muni bonds is that the information about them is KEPT UNDER LOCK AND KEY. If I just want access to the offering statement on a bond that isn't a new offering, I would have to pay through the nose to get the document. As an individual investor, I don't even have access to the UNDERLYING credit rating of the bond. I ONLY have access to the rating with insurance (which is likely BOGUS if it's Ambac or Mbia, FGIC, etc.)

The information SHOULD NOT BE KEPT UNDER LOCK AND KEY at exhorbitant prices! It SHOULD BE FREELY AVAILABLE!

Anonymous said...

ARS involve a Dutch Auction in which the lowest bid that clears the auction determines the yield. At the end of the period, such as 7 days, you receive an interest payment. If you don't do anything, your position is "held at market" in which the next auction will determine your yield.

Fidelity does a good job explaining everything. Here is a link, and HOPEFULLY the blog page can handle a link this long:

http://personal.fidelity.com/products/fixedincome/muniresets_overview.shtml.cvsr

Anonymous said...

Guess not!

the muni investor said...

AI, I had a question about ARS's. I'm looking at ARS's as long term debt packaged as short term vehicles. Now, this would make sense only if say the difference between long term and short term rates is fairly large (large enough to offset the costs of weekly auctions etc). Is this assumption correct ?

Right now, we are coming off a period where the yield curve was fairly flat in the muni market and inverted for a long period of time in the corporate segment. In such circumstances, wouldn't munis want to move their debt from ARSs to longer term debt ? Wouldn't that make more sense financially ? Why pay the additional cost for auctions, specially given that long term rates were near historic lows in the last few years. (30 year rates barely cross 4.5% less than a year back).

Very clearly, there must be some added incentives for munis to want to stay in the ARS market. Thoughts ? Have I missed something ?

Regards.

Anon - about credit rating of the underlying muni, Schwab has started providing information about the rating of the muni in addition to the rating with the insurance. If you are a bond holder, then you are entitled to the offering statement. I don't know if you can get the offering statement of any random muni that you might be interested in - AI had pointed out that munios.com provides some of this information. I see only statements for new issues, not older ones there.

Dave M. said...

"" AI had pointed out that munios.com provides some of this information. I see only statements for new issues, not older ones there.""

Go to investinginbonds.com then key in your cusip in the box, after you select corporate or municipal category. It will open a new window with all recent transactions. At the top, you can click on munistatements. That's how I've gotten some looks at the bond issue itself.

the muni investor said...

Anon who provided the link, you can enclose a link in a href tag or use tinyurl.com to shrink the url. I did not find the exact link which you were referring to, but here is a page on fidelity which talks about the dutch auction

Link to fidelity

Anonymous said...

Unbelievable...

After all the turmoil in the markets with AAA rated mortgages and asset backed paper, people are asking what is the credit rating on munis?

Let me save you a lot of money and time: S&P and Moody's have no idea what the credit worthiness of these bonds is.

Accrued Interest said...

Munis can be hard to research, because they aren't SEC registered or anything like that. investinbonds.com is a great resource. Moody's and S&P offer some information for free on their sites. SOME.

I really need to write something about Jefferson County...

Anonymous said...

You got it wrong AI. Muni arb saw rapid nav reductions that lead to delevering primarily because their levered muni positions dramatically fell in value not because their LIBOR/Treasury/BMA swaps moved against them (though that did contribute some). To make matters worse their prime brokers moved up margin requirements and then applied discounted marks to those provided by reputable third parties such as JJ Kennedy. Death spiral then ensued.

Accrued Interest said...

I heard the same thing about margin reqs being upped. But to be fair, muni rates were not behaving like taxable rates, which means their hedges weren't working. It really doesn't matter much for the discussion at hand, but that's all I was trying to say.

Anonymous said...

Fair enough.

It's interesting to note that taxables and munis haven't been behaving well since July. Many muni arb funds saw 20-100% markdowns in both August and November.

I believe what started the whole thing was a multi strat FI fund had some mortgage trades go sour (Falcon is the rumor) and was forced to offer its entire muni portfolio to meet margin. The rest is history.