Market Close: Rate Hike Fears Put Choke on Short-Term Munis

The value of municipal bonds plunged Thursday as the prospect of rising interest rates triggered a selloff, with short-term bonds taking the hardest hit.

Yields on bonds maturing between three and seven years jumped by as much as 11 basis points, while bonds maturing in eight to nine years softened by up to five basis points. The curve beyond 10 years was weaker by a few basis points in some spots.

"I see the front end of the curve kind of getting hammered," a West Coast trader said in an interview. "We are seeing pretty big cuts up on the first five years."

The market is still reacting to Wednesday's commentary by Janet Yellen that the Federal Reserve may hike interest rates in early 2015, traders said. Other market participants said Thursday's selloff was a bit extreme.

"The selloff could be a little bit of an overreaction, not so much on the short end but in the intermediate range there is a sell off," Bernard Garruppo, chief executive officer at Granite Springs Asset Management, said in an interview. "I'm a little surprised the long end has not sold off as much, but yes, I think it's a bit of an overreaction."

The demand for short-term investments seems to be shifting toward long-term paper, traders said. Short-term bonds that have firmed in the past six months may be overvalued, market participants told The Bond Buyer earlier this month.

Strategists said a non-traditional approach to managing interest rate risk may be a smarter play this year, as prices on short-term bonds may outweigh the rate-risk benefits they offer.

"People may be lightening up on some of the shorter end, and investing in the long," said the same West Coast trader. "Investing in long is not something I would be doing, but I like seeing the front end get hammered so I can pick up some stuff."

Investors' flight to short-term bonds started in June 2013 when then-Federal Reserve chairman Ben Bernanke announced that the Fed planned to taper its monthly $85 million bond buying program. This demand for short-term bonds collided with a historically low issuance for the beginning of 2014, creating supply-demand inequality and driving up short-term bond prices.

For traders hesitant to buy expensive short-term bonds this year, Thursday's selloff presents an opportunity to buy bonds during a week of low issuance in the primary market, and unattractive prices in the secondary.

"I like seeing a bit of a sell-off though, because it makes more of an opportunity for clients to reinvest," Garruppo said.

The weekly jobless claims report, released Thursday morning, added to interest rate concerns. Claims rose to 320,000 for the week, on the low end of what economists expected and down from a month ago, when there were 334,000 claims. The figure marks a 5,000 jump from 315,000 the previous week, according to the Bureau of Labor Statistics.

"If claims go down, that will be positive to the economy as a whole, and lead to higher rates," said the trader in the West Coast.

The four-week moving average dropped to 327,000 from 334,000 this time last month, the report said. The jobless claims numbers were anticipated by some traders, who said that the report added to concerns that developed Wednesday after Yellen's remarks.

"I did not think claims would affect the market that much, but an early read on the MMD scale showed there are significant cuts, which I'm surprised by," Garruppo said. "But personally I think that has a lot to do with what our Fed chairwoman said yesterday."

Treasuries yields jumped as much as eight basis points on the 10-year benchmark, ending Wednesday on a weak note.

"The Treasury market may be affected by the tapering a bit, and munis tend to follow Treasuries, but it won't directly affect the muni market," a different West Coast-based trader said.

The spread between yields on 30-year and 10-year Treasury bonds fell to 88 basis points Thursday morning, the lowest since May 24, 2010, according to Thomson Reuters data.

Treasuries ended the day with the 10-year and 30-year bonds softening by as much as two basis points to 2.78% and 3.67%, respectively. Two-year notes remained steady at 0.44%.

Issuance this week has remained light following last week's $11.4 billion supply, which participants said was readily handled by investors. Many traders added that secondary market prices have not been appealing.

"There is largely nothing attractive in secondary — it's been ugly," the West Coast trader said.

In the primary, the state of Wisconsin planned to issue $393.61 million of transportation revenue and refunding bonds Thursday, the largest deal in the negotiated market. The issuance did not come to market by Thursday afternoon.

The bonds are expected to carry a Aa2 rating from Moody's Investors Service, and AA-plus from both Standard and Poor's and Fitch Ratings, according to Thomson Reuters. Jefferies is lead underwriter.

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