February 17, 2009
Value persists in the market
The flight to safety beginning in August, 2007 drove Treasury yields below those of comparable munis — a dislocation that has persisted since then to varying degrees. But, spreads relative to Treasury bonds have contracted recently. In December, munis were trading with yields 200% those of comparable 10-year Treasury bonds, and now that spread is a little bit over 100%. Historically, the average spread is 86-90% of Treasuries.
Source: MMA, Bloomberg
Spreads will eventually return to historical levels as yields on Treasury bonds increase and investors become less risk averse.
Doe is also concerned about a lack of supply in the muni bond market. At the end of the 1990s, muni bond issuance averaged approximately $200 billion per year. This ballooned to $400 billion a year prior to the onset of the credit crisis because of surging demand from hedge funds and institutions. Doe forecasts $300 billion of issuance for 2009, but that may not be enough to satisfy demand from individual investors.
“It may be difficult for investors to get exactly what they want,” Doe says. But bond holders will benefit as the supply/demand imbalance drives up prices.
The level of support for states and municipalities in the stimulus bill is uncertain, and it is unclear whether TARP funds will be used to support the muni market. House Financial Services Committee Chairman Barney Frank, D-Mass, has suggested that the government should provide insurance to backstop municipal GO bonds.
“A lot is in flux,” says Doe. But Washington has a strong incentive to keep the ratings of muni bond issuers at the highest levels, knowing that these issuers badly need access to the debt markets.
“The long-term damage of a state’s default is unimaginable,” says Doe, who is confident government funds and tax revenue will support the muni bond market.
“Some states will raise taxes beyond anyone’s interest in living there,” says Doe wryly, “but, in the end, it will all work out.”
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