Monday, December 29, 2008

Bad liquidity cuts both ways in municipals

Municipal bonds have posed an impressive rally in the last few days: the Barclays Municipal Index is up 3.78% since 12/15. That is better than either the Treasury market (+1.55%) or the S&P 500 (+0.57%) over the same period. As much as I think munis are a great value here, this rally has more to do with illiquidity than anything else, and it is a stark lesson for anyone looking to trade fixed income over the next year.

First, consider why municipals have performed so poorly recently. The Municipal Index had fallen over 9% from September 11 through December 15 before rallying this past week. During the same period, the Treasury market rose over 7%. Its easy to point to credit worries about municipal issuers, after all, state budget woes are a constant headline. But this can't explain poor muni performance in its entirety, after all, even munis backed directly by Treasury bonds in escrow haven't been immune from the sell-off.

A better explanation is that many of the biggest holders of munis have become forced to raise cash in recent months, particularly mutual funds and insurance companies. In the old days, the broker-dealer community would have bought up these bonds, held them on the balance sheet, and eventually sell the bonds to another customer for a profit. In essence, dealers used to serve a sort of wholesaler function, holding bonds in inventory while looking for an end-buyer.

Today, dealers are no longer willing to hold bonds on balance sheet. This means that if customers want to sell municipal bonds an end buyer must be found first. If the seller needs immediate liquidity, s/he is at the mercy of whatever end-buyer happens to have available capital at any given moment. Not surprisingly, this results in lower prices on bonds.

But that same illiquidity cuts both ways.

Recently, buyers have emerged in the municipal market, spurred in part by the Fed's aggressive rate stance as well as a desire to add duration before year-end. But whatever the reason, buyers are finding that dealers have no bonds to sell. Buyers want to buy at "forced sale" prices, but are finding a dearth of forced sellers.

Now those that want to buy are having to pay prices high enough to entice current municipal bond holders to sell, thus pushing the trading price of municipal bonds dramatically higher in a short period of time.

You can imagine brokerage firms having once acted like a buffer between buyers and sellers. They were willing to buy when the market wanted to sell, and then sell when the market wanted to buy. Now they are acting like true brokers, matching buyers and sellers, but not putting the firm's capital at risk either way.

What does this bode for municipals going forward? Difficult to say. Munis offer very strong long-term value, but the technical picture is cloudy. But this whipsaw trading should serve as a warning to anyone involved in the fixed income markets. The lack of market making activity isn't unique to municipal bonds. The situation is similar in almost all bond types other than Treasuries and large issue government Agencies. And we should expect the same kind of whippy price action in other sectors as well.

It thus represents both an opportunity and a danger. If you are willing to buy when others are selling, you can buy good bonds cheap. This is true in various sectors, from hybrid-ARM MBS, to municipals, to commercial MBS, to corporate bonds.

But one also needs to be careful assuming that fixed-income sectors are moving for fundamental reasons. Right now, to assume that the current muni rally is some sort of all-clear sign is a mistake. The muni market didn't suddenly forget all of the problems facing municipal bonds, both fundamental and technical. Rather certain buyers came into the market, found the primary calendar empty and secondary supply sparse. The result? Higher prices. There really isn't anything more to it.


Unknown said...

Is this why the muni tobacco bonds are so cheap? They are selling in the $60-70 area. Current yield of around 9-10%. What am I missing here? Philip Morris going bankrupt? MSA getting revamped?

Andrew Moloff said...

Wow, so let me see if I can understand what you are saying: the price of munis went down because a lower price was required to clear the market. Then it went up because a higher price was required to clear the market?

Piercingly insightful.

PaulinKansasCity said...

It is insightful as Tom has a "real world" view of trading in these markets as a professioal bond trader. Since the bond dealers aren't providing any liquidity on their end to store inventory when demand increased their was not a ready pool of inventory to sop up the demand; just as when supply was more plentiful from willing sellers the bond dealers were not absorbing some of this on their books. In the past as AI has mentioned leverage allowed for much more stable pricing; with that leverage now unavailable the bid/ask spreads are much wider and we will have muchmore volatile markets.

AI; tell me I get a passing grade!

Great blog!

Paul in Kansas City

Unknown said...
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Unknown said...

gingersue: tobacco bond prices have been driven down by not only the lack of demand in the tobacco sector (like all other muni HY sectors), but even further by the mid-Dec "light" cigarette ruling. The ruling allows tobacco companies to be sued for "deceptive" advertising, which will put even more pressure on the finances of tobacco companies.

In January, we're going to see a muted January effect in the muni space. The usual snapback is going to be short-lived as deferred supply will start to flood the market.

Accrued Interest said...

Andrew: Wouldn't every analysis of market movements boil down to lower or higher prices needed to clear the market? The question is why is a different price needed?

Ginger: I agree with Riyadh. There are some fundamental problems with tobacco bonds. Also those that are jumping into munis are doing so in very high quality issues. Other lower-rated issues, hospitals for example, are still at or near their lows.

jiHymas said...

Much the same thing has happened in the Canadian Preferred market, which has a similar investor profile for similar reasons of taxation; in our case, the prefs get margined like stocks so there's even less incentive for brokers to maintain inventory.

The market was crushed by tax-loss selling in November and December-up-to-the-last-tax-loss-selling-day ... so far, anyway, it's making a gigantic comeback.

Unknown said...

Riyadh, thanks for your comments but I'm not that worried about the recent "lights" deceptive advertising ruling. I think that the economic gain from such lawsuits to the plaintiffs will be minimal and law firms will be hesitant to litigate thses cases on a contingency basis. Suing Philip Morris is very expensive, time consuming and will be drawn out for years via appeals.

Unknown said...

To add another point, I note that most class action lawsuits for deceptive advertising usually result in lawyers making a couple of million and the consumers getting a coupon for a free pack of smokes. I fail to see the big liability risk to the tobacco companies here in this decision. Am I wrong?

Unknown said...

So the municipal market witnessed a liquidity driven sell-off from September to mid-December, and some liquidity returned to the market and prices went up. Perhaps the recent rally does not signify better credit conditions because, as stated, the sell-off was linked to liquidity in the first place, not deteriorating credit (broadly speaking).

Unknown said...

Ginger: You may be right that the ruling would not have long term material impact on tobacco companies' ability to repay their debt. However, I do imagine that it's another factor that will compound the negative perception of the sector, and in turn depress prices to some extent.

Unknown said...

Riyadh said.."it's another factor that will compound the negative perception of the sector, and in turn depress prices to some extent."

And that usually dovetails into opportunity. Such as 8-10% returns Tax-free!