Munis at ‘once in a decade’ bargain levels

The municipal bond market is recovering after a period of extreme turmoil last month during which buyers disappeared and trading froze up. Despite a strong rally since then, observers say, some longer-term municipal bonds still offer yields almost equal to taxable paper — an extremely rare event — and remain attractive buys. Weakness in municipals combined with the flight to Treasury bonds “led to probably the best opportunity in many years” for tax-free investors, said Ken Meiselman, executive vice president and head municipal trader at JBHanauer & Co. of Parsippany, N.J. At one point, long-term tax-free yields broke above 5%, or about 110% of the yield on equivalent Treasuries, he said. “We see that maybe once a decade,” Mr. Meiselman said.
Lost confidence The market witnessed a complete loss of confidence Aug. 16, as leveraged institutional holders of municipals saw their interest rate hedges go against them, which forced widespread selling to meet margin calls. “There were literally no bids in the municipal bond markets,” said Thomas Doe, president of Municipal Market Advisors, a Concord, Mass., research firm. “I’ve been in this business for 26 years, and I’ve never seen that,” he said. It wasn’t until Merrill Lynch & Co. Inc. of New York was forced to buy a half-billion-dollar Missouri highway bond issue that market participants felt a floor had been reached and started buying, Mr. Doe said. Higher-yield municipal bond funds were hit especially hard last month. The 103 high-yield-muni funds tracked by New York-based Lipper Inc. lost 2.82% in August, the worst-performing tax-free category, according to Lipper. Lower-quality bonds were “tangentially tied to subprime concerns,” Mr. Doe said. High-yield tax-free-bond funds had been leading performers for the year until they were hit by the panic, Mr. Doe added. Since the August bloodbath, municipal bonds have rallied strongly. There’s been a “pretty violent rally” over the past three weeks, Mr. Meiselman said. Mr. Doe said buyers have been engaging in a “grabfest” for tax-free bonds. With bond prices rallying over the past three weeks, observers said, yields on long-term tax-free bonds have fallen 0.4 percentage points. Retail advisers have used the market weakness to lock in attractive yields for clients. “A lot of wirehouses [recently] had ... some of their busiest [municipal trading] days in history,” Mr. Doe said. Mr. Meiselman said brokers have been getting clients to extend their maturities now that the yield curve has steepened. The 4.6% tax-free yield on long bonds “is still a great deal for investors,” he said. Investors have been coming back into bond funds, as well. Beginning this month, flows into tax-free-bond funds turned positive once again after the funds suffered outflows during August, according to AMG Data Services of Arcata, Calif. While yields remain attractive, observers said, in the short term, the market may be overbought. In addition, potential new supply is stacking up. “There are a lot of new deals on [syndicate] calendars,” Mr. Doe said. About $9 billion worth of new issues was postponed in August, and underwriters are “now waiting day to day to sell it,” said Matt Fabian, a Westport, Conn.-based senior analyst with Municipal Market Advisors. “That’s a ... lot of paper hanging around.” On average, about $8.3 billion in new municipal bonds have been sold each week this year, Mr. Fabian said. Dominated by leverage The selling pressure and freeze-up of the municipal market is a result of the fact that most of the liquidity was created by leveraged buyers, including banks, brokerage firms, mutual funds and hedge funds. Many of these entities run what are called tender-option-bond programs, Mr. Fabian said. In these structures, long-term bonds are leveraged with floating-rate debt, put in a trust and sold to mutual funds that get a tax-free dividend yield for use in money funds, Mr. Fabian said. TOBs hedge their interest rate risk, but when the flight to quality drove down Treasury and London interbank offered rates, the hedges lost money at the very same time municipal bond prices were falling, Mr. Fabian said. As a result, these institutional buyers were forced to meet margin calls by selling bonds. “The selling was of a magnitude beyond the capital available to provide liquidity,” Mr. Doe said. “Ironically, many of those same [brokerage] firms that were selling would normally be providing liquidity [to the municipal market].” The municipal market “isn’t as liquid as people lead you to believe,” Mr. Doe added. “It’s one-dimensional — dominated by this one type of [leveraged institutional] buyer.”