Quietude remains the municipal bond market’s best friend.
The growing consensus on the Street is that municipal debt would be taking a hit if only there were enough transactions to illuminate the weakness that pervades the market.
The Municipal Market Data scale was unchanged again on Friday, with 10-year triple-A bonds holding in at 3% and 30-year triple-A paper holding at 4.78% — the same yield every day for the whole week.
Don’t buy it. If you’ll forgive a harsh analogy, not opening the refrigerator because there’s spoiled meat inside doesn’t make the meat smell any better.
Demand for long-term paper remains thin, and virtually all the minimal supply that has come to market is high-grade. The market passed a $4.5 billion supply test last week, but it remains to be seen how it could handle lower-quality paper or any real swelling in volume.
Even top-rated deals aren’t going 100% smoothly, as evidenced by the unsold balances that remain from the $485 million Maryland deal still lurking in dealer inventories.
“We’ve all acknowledged the municipal market is somewhat of a sick market,” said a trader in New Jersey. “These aren’t levels that I want to stock bonds at. I don’t want to take risk here at these levels.”
Would-be sellers are seeking bids on more than $790 million of municipal bonds, which is the highest since mid-February, according to a Bloomberg LP index tracking bids-wanted.
It’s one of the ironies of the bond valuation business that when people seek bids on bonds and get no offers, the price evaluations remain unchanged. Once more supply forces bonds to move, we’ll find out fair prices are lower than they are now.
“The last few days you’ve seen all these bid lists come out, but not much trading,” one trader in New York said. “You see the scales at the end of the day unchanged, and it’s like, 'That doesn’t really feel right.’ That’s not the market tone out there. It’s the lack of the actual ticketing stopping the cuts from happening.”
This trader said the market was “certainly weaker” on Friday.
Despite the weakness that we’ve argued all week underlies the market, the lone deal to price Friday — the Tulsa County, Okla., Independent School District No. 4 — was benign for two reasons.
One, it was only $9.2 million. Two, its longest maturity is 2016. The municipal market is doing fine with shorter maturities. In fact, the MMD scale last week actually strengthened as much as four basis points for short maturities. It’s the long maturities where buyers are scarce.
Then again, the optimists do have some things to point to.
State and local governments are slated to sell barely more than $2 billion of debt next week, and it’s looking more and more likely the market will work through the entire first quarter and more without the supply surge people were worried about.
How to Disguise Duration Risk
Last week we examined two types of insurers — life and property-casualty — to show why they’re usually unwilling to hold long-duration tax-free bonds. Most of the two industries’ nearly $6.6 trillion of combined financial assets either have a duration tolerance too short for the kind of interest rate risk imposed by 20-year-plus maturities, or are taxed at too low a rate to warrant buying tax-exempt debt.
Our intention is to comb through the buy-side category by category to underscore the lack of demand for municipalities’ long-term debt in each investor class. Today we’ll look at money market funds.
Money market funds are parking places for cash. They invest only in super-safe, super short-term paper.
Money market funds hold about $335 billion of municipal debt, according to the Federal Reserve, most of which is variable-rate notes with a put option.
It might seem peculiar to include money funds in any discussion of duration, considering the bulk of their holdings matures in seven days or less. Money funds’ tolerance for duration risk is almost zero. They can’t ever brook a loss of 1%, even if it’s rounded up from a fraction of 1%, so clearly they can’t hold instruments with any real vulnerability to an increase in interest rates, let alone 20- or 30-year fixed-rate bonds.
The average tax-free money fund holding matures in 28 days, according to iMoneyNet. The biggest tax-free money fund, the $23.3 billion Fidelity Municipal Money Market Fund, keeps more than 80% of its assets in holdings that mature within a week.
In truth, although money market funds perhaps may never have been direct absorbers of duration, they enabled the absorption of municipalities’ long-term debt on a massive scale until a few years ago.
Money funds enabled buying of long-term municipal debt in two ways: by providing the leverage for tender-option bond arbitrage, and by buying variable-rate demand obligations.
These two types of vehicles used to take on a significant amount of municipalities’ long-term debt. While they’re both still somewhat active, their share of new volume has diminished severely.
Oversimplified, the TOB arbitrage structure essentially entails borrowing money at a short-term rate from a money market fund, and using the borrowed money to buy a long-term muni.
The spread between what you collect on the bond and what you pay on the short-term financing is a leveraged spread profit.
TOB arbitrageurs reportedly used to hold as much as $300 billion to $500 billion of municipal debt, most of it long-term because the whole point of the trade was to take advantage of the steep tax-exempt curve.
Municipal Market Advisors’ Matt Fabian once estimated the leveraged TOB funds used to purchase a quarter of all municipal debt, which would have taken care of most long-term supply.
The sources we’ve spoken to have said TOBs are still out there, but are far diminished in size. Even though the extremely steep curve and near-zero financing rates from money funds argue for the trade, sources say the appetite for leveraged arbitrage has shrunk. While these funds used to provide a way to transmit money-fund demand to the long end of the curve, that trade isn’t absorbing long-term supply the way it used to.
The other role money funds played in absorbing long-duration municipal debt is buying variable-rate demand obligations. The VRDO structure is a nominal long-term maturity whose interest resets at frequent short-term intervals in a remarketing.
That way, municipalities were borrowing money for long periods and paying short-term rates. The only rub is that governments have to pay a bank to guarantee liquidity in order to induce money funds to keep buying this kind of paper.
This option for raising long-term proceeds is all but toast. Municipalities thought that by hiring a bank every few years to guarantee their VRDOs, they were unloading their duration risk.
Not at all, it turns out. Municipalities have discovered to their horror that through the VRDO structure they found a most unsuspecting taker for their duration risk: themselves.
The need to line up bank financing every two or three years to support long-term debt means municipalities simply transformed their duration risk into remarketing risk, rollover risk, and basis risk.
A market that once grew to about $450 billion outstanding was never a solution to the lack of demand for long municipal duration. It was just a place to hide it.
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