Among the many metamorphoses the advent of taxable Build America Bonds was anticipated to induce in the tax-exempt municipal bond market, one of the most important was the flattening of the yield curve.
It has not happened yet.
Even with BABs transforming the municipal supply-demand dynamic more than almost anyone predicted, the muni yield curve remains steep.
The yield curve depicts how dramatically interest rates ascend with longer maturities. A steep yield curve describes investors’ preference for short-term debt relative to long-term debt.
When the federal government created the BAB program in February, some people thought it had the potential to flatten what has long been a steep curve.
Municipal investors traditionally prefer shorter-term debt. State and local governments, meanwhile, like to issue long-term debt. That mismatch for decades has kept the municipal curve steeper than many other types of curves.
The theory went like this: under the BAB program, the taxable bond market would poach a hearty share of long-term bonds out of the tax-exempt market. That would deplete long-term municipal supply, plugging the gap between supply and demand at the long end that kept rates high for so long. That would bring long-term rates down and flatten the curve.
At the beginning of 2009, 30-year triple-A municipals yielded 315 basis points more than two-year triple-A munis, based on the Municipal Market Data scale.
A year and $64.1 billion of BABs issuance later, the 30-year-over-two-year curve had steepened 40 basis points.
The current spread of 350 basis points is still 130 basis points higher than the average over the past 10 years.
That is hardly transformative.
To be fair, the steepening in the municipal curve compares with a 160-basis-point steepening in the Treasury curve to end 2009 at a 30-year-over-two-year spread of 350 basis points, and a 185-basis-point steepening in the London Interbank Offered Rate curve to finish 2009 with a spread of 310 basis points.
Still, the current municipal curve shows investors remain biased against long-term muni debt despite the drainage of supply into the taxable market.
“In theory, yes, we would have thought it would have flattened it,” said Neil Klein, a portfolio manager at Carret Asset Management. “What you’re seeing in the steepness of the yield curve is there still is demand for short-term bonds.”
Klein said his clients still are loath to reach for long-term paper despite the high yields because the Federal Reserve is likely to raise its target for interest rates this year.
People would prefer to stay in shorter-term debt and wait for the opportunity to invest after rates have already risen, Klein said, rather than lock themselves in for 20 years or more.
“If there’s a perception that rates will be better down the road, you don’t want to tie yourself in for a long period of time,” he said.
Add to that jitters over inflation and municipal credit, and investors remain skittish about stretching out too far. Klein emphasized that he thinks the worries about inflation and credit are overdone, but he believes they are driving the market.
The municipal team at DWS Investments still expects BABs to flatten the yield curve at some point.
The team, which is led by Phil Condon, in a white paper published this month argued BABs have “mitigated some of [the curve’s] steepness.”
Because of the way the bond math works, many municipalities have found it cost-effective to issue tax-exempt paper for short and intermediate borrowing, and taxable debt, including BABs, for long-term borrowing.
“This is reducing the supply of long-dated tax-free bonds more than short-dated tax-free bonds, and reshaping the municipal yield curve in the process,” the DWS team said.
Condon expects BABs to flatten the curve as a greater portion of long-term issuance seeps into the taxable market.
George Friedlander, municipal strategist at Morgan Stanley Smith Barney, last week predicted $110 billion to $130 billion in BAB issuance this year, which would represent as much as 30% of his forecast for total muni debt issuance.
Before last year, taxable municipals seldom contributed more than 10% of issuance.
In a conference call discussing the white paper, Ashton Goodfield, head of municipal trading at DWS, offered one reason why BABs have not flattened the curve as much as people expected.
With the variable-rate debt market hobbled, many municipalities have been restructuring out of short-term debt and into long-term, fixed-rate debt.
That has saddled the market with additional long-term supply, muting what might have otherwise been a flattening influence from BABs.
The steep municipal yield curve has long confounded investors.
Since 1990, the 30-year-over-two-year triple-A muni curve has been, on average, more than 50 basis points steeper than the Treasury curve.
Academics have dubbed this disparity the “municipal puzzle.”
An entire sector of hedge funds sprouted up in the last decade to try and arbitrage this perceived inefficiency. They tried to collect a long-term municipal rate and pay a short-term municipal rate to profit off the steep yield curve, but the financial crisis detonated the hedges they used and many of the funds collapsed.
Condon said BABs have the potential to do what the hedge funds could not: endow municipal bonds with a yield curve shaped more like a taxable curve such as Libor.