What the hell is going on with munis?

To understand what's happening in munis, and why its got so many people worried, you first have to understand how it used to work. You know, way back in early 2007.

When a municipality wanted to do a bond issue, they would hire an investment bank, who would normally invite other investment banks into the deal to help sell it. Not unlike what happens with corporate bond or even equity IPOs. The lead investment bank would decide on an interest rate it thought was the right level to sell the bonds. They'd set the level a little higher than the market, in the hopes of selling the deal quickly. Remember that a municipal bond issue is underwritten, meaning that the investment bank has committed to buy the issue from the municipality, and is taking the risk that they can sell the deal to the public.

Way back in early 2007, that risk seemed like no big deal. If a bond deal didn't sell in its entirety, the dealer would just put the bonds out on its retail system and sell them to mom and pop $5,000 at a time. Given the underwriting fee the investment bank earned, the risk of holding low volatility municipals for a week or so made a lot of sense.

Fast forward to today. Investment banks are generally strapped for capital. What capital they do have is not being heavily allocated to a low margin area like municipals. And a lot of the dealers' municipal capital is tied up in auction rate bonds.

So what happens when an investment banks is trying to underwrite a municipal deal but have been told not to use any of the firm's capital? They have to "pre-sell" the entire issue, meaning that the bank's customers have committed to the deal before the official sale. No big deal, right? Just set the price a little higher than the market, just like muni underwriters have been doing for years, and demand will come, right?

Well, not so fast. New issue muni supply is extremely large right now: over $8.4 billion in new issues are expected next week. A lot of that is auction-rate securities being refinanced. On top of that, there has been consistent selling from various municipal arbitrage strategies, such as tender-option programs. These strategies have been squeezed by bad hedges and insurer-related downgrades, and are currently flooding the market with bid lists.

Normal muni demand from mutual funds, insurance companies, and mom and pop investors just can't keep up with that kind of selling. And with dealers unwilling to inventory bonds themselves, that means that they have to make new deals so cheap as to entice non-traditional muni buyers into the market. In other words, vulture investors. The same people who have stepped in to buy auction-rate munis yielding 8% are now being invited into the fixed-rate muni market.

What's the result? Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50's. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt. Dozens of large new issue municipal deals came at significant spreads to Treasury rates.

The hedge funds are smelling blood in the water, and are moving in quickly. I've heard from multiple sources that non-traditional muni buyers, from hedge funds to taxable bond investors, lifted everything in the street yesterday. That's good news and bad news of course. It means that the muni market is indeed clearing. But it also means that muni rates can't move substantially lower (at least versus Treasury rates) until we get through this glut of new issue supply created by auction-rate refinancings and arb selling. These vulture investors don't really represent new demand for munis long-term, merely that if the street is going to absolutely give away municipals, there are buyers who will take them.

A trader I talked to today told one of his hedge fund clients that municipals were feeling like a falling knife. The customer responded that the ABX index was a falling knife. This is at worst a butter knife.