The hunt is on for yield in the municipal market as interest rates continue to hover around historical lows, forcing investors to use varying strategies to boost returns.
Some investors are venturing down the credit scale while others are making deeper incursions into the primary market. Some, including dealers trading large blocks, are participating actively, more confident about holding inventory in a falling rate environment.
Still others, such as institutions and mutual funds, are feeling pressure to stay invested but are apprehensive about ultra-low yields.
The reach for yield has been the real story, given the low absolute rate environment that munis find themselves in today, according to BlackRock’s muni strategist Sean Carney.
“In 2011, if you look at performance based on Barclay Capital’s indices, one was rewarded for being long duration and accepting risk through higher beta securities,” Carney said. “Thematically the market is acting very similar today — everyone wants and needs yield, and as long as investors are being rewarded for reaching that will not change.”
Triple-A muni yields have fallen throughout most of 2012. They rose on the week, but still rest at almost prohibitively low levels.
The benchmark 10-year triple-A yield reached a record low of 1.67% on Jan. 18, according to Municipal Market Data. Through Friday, it has fallen from a 2012 high of 2.33% on March 20 to 1.90%.
The two-year muni yield hovered at an all-time low of 0.26% on Feb. 16 through March 7. It currently sits at 0.32%, 10 basis points from its high for 2012 of 0.42%.
The 30-year hit 3.04% on June 1, a record low, and rose to 3.18% on Friday. Still, it has sunk from a high in 2012 of 3.57%, set at the start of the year.
For the wealthy households that comprise the retail portion of the market, these yields have led to more or less participation in the marketplace, depending on whose opinion among industry analysts one elicits. One view holds that retail is active, despite the rate shock, because they still don’t see where else to put their money.
Individual investors are buying, said Bill Walsh, president at Hennion & Walsh, a wealth manager and muni specialist based in New Jersey. “On the retail side, you’re seeing bonds being bought; they’re putting them away,” he said. “There’s certainly trading activity going on.”
But retail buyers are selective, he added, and that means they’re looking at the issuers. “You’re seeing a lot of interest in [general obligation bonds] and essential-purpose revenue bonds, things that, if the economy doesn’t continue to inch higher, are strong and safe investments for them,” Walsh said.
But another view holds that retail participation in the market has softened because of the low rates. John Hallacy, municipal research strategist at Bank of America Merrill Lynch, makes that argument in a research report.
Employing a proprietary formula the firm uses to determine retail interest, Hallacy wrote that there has been a strong positive relationship between the level of muni rates and the amount of direct retail demand.
“While we expect retail demand to remain weaker at current levels,” he wrote, “any backup in rates would likely be met with strong increase in retail demand.”
Separately managed accounts have had to adapt to higher dollar prices when purchasing securities, Carney added. This is shown by underwriters having to adjust coupons between retail, which need 3% and 4% coupons, and institutions and mutual funds, which continue to prefer 5% coupons, he said.
Interdealer trading activity has climbed since September, since yields have been falling from roughly 17% of the market to around 22%, according to Municipal Securities Rulemaking Board numbers. When the market feels stronger or dealers’ views of the market are more favorable, they are more willing to buy and hold more inventory, Carney said.
Interdealer or “Street” trades represent those trades where bonds change hands for any number of reasons. Interdealer trades mostly involve moving larger, wholesale-type blocks from a dealer who has the bonds to another who has a customer buyer.
Those trades where bonds leave the market, or “go away” directly to customers, signify customer trades.
Volume plays a role, as well. Primary supply has climbed 72% through the first five months of 2012, compared with the same period in 2011.
And as volume rises in the primary, dealers are willing to chase opportunities there and unwind more of their inventory. That has led to more dealer activity.
“When you see the interdealer support begin to pick up, you realize that there are some bonds that are either being crossed, or swapped, or going into liquid inventories, bonds that can surface back into the market,” Carney said.
Muni bond mutual funds continue to see sturdy inflows, mostly in long-term and high-yield funds, according to Lipper FMI numbers. Mutual funds have also benefitted from the search for yield, as some retail investors that have seen their bonds get called away have reinvested the proceeds in funds rather than individual bonds. That’s because mutual funds tend to offer higher yields due to their innate book yield, Carney said.
Fund yields are higher than new offerings in falling rate environments because they have a pool of higher-yielding bonds from which to draw. But their yields can lag in rising rate markets.
In the current low-rate environment, many funds have been maintaining higher cash balances than typical while they wait for higher yields and wider spreads, said Peter DeGroot, a muni strategist at JPMorgan. But most funds cannot remain in cash indefinitely, as large cash holdings have hurt fund performance against peer- and total return-based benchmarks, he added.
In addition to maintaining higher cash balances, some funds now have more conservative duration limits, DeGroot said, instead opting to increase their allocations in the lower-rated sectors of the market.
Finally, big institutional players such as property-casualty and life insurance companies and commercial banks are steadily allocating capital to munis. But they are less active than they might otherwise be, given the low rate backdrop, DeGroot said.
Both groups have cash to spend. Banks have seen surging deposits for an extended period and have sizable investment capital. The insurers have cash on hand in light of low claims from natural disasters and increased price elasticity.
“These buyers have been more conservative in curve allocations than in prior periods,” DeGroot said.
In addition, the secondary market has appeared locked to them, said Phil Villaluz, head of municipal research and strategy at Sterne Agee. Investors have been unwilling to sell when they can’t replace the yield, and unwilling to buy at absolute yield levels that are so low where prices seem too rich, he added.
“There is money coming into [institutional] funds; there’s reinvestment cash to spend,” Villaluz said. “But all the good ideas aren’t going to get much traction if you can’t find paper.”
The lack of paper has focused attention on supply dynamics in the primary market. He said institutions are looking more closely at new deals and watching to see if any bump in offerings provides them an opportunity to pick up a few basis points more in yield.
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