A wave of buying, fueled by record yields and unprecedented government support for infrastructure financing, has breathed new life into the municipal bond market, which found itself at death’s door after the credit crisis last year.
In the first quarter of 2009, mutual funds bought $16.5 billion in municipal bonds, increasing their total assets in this category by 4.2 percent, to $406.1 billion, according to the Federal Reserve Board. That follows a quarter in which they sold 2.4 percent of their muni holdings. Corporations, impelled by a drift to historical lows in Treasury yields, also increased their municipal bond assets, adding $10.1 billion worth to bring the total to $17.8 billion. Even renowned investor Warren Buffett increased the total muni holdings of his company, Berkshire Hathaway, by $985 million in the first quarter.
“The municipal market’s on its way back,” says John Cummings, head of the municipal trading desk at bond giant Pacific Investment Management Co. in Newport Beach, California. “It lacks liquidity, and the trading volume is light, but it’s healthier than it has been in some time.”
The traditionally mellow muni market took a beating following the collapse of the subprime mortgage market, as monoline insurers like MBNA and Ambac Financial Group stopped writing policies on munis. In 2008 municipal bond financing fell 8.97 percent, to $391.3 billion, from $429.9 billion in 2007. The reduced figure is still higher than 2002’s total of $358.4 billion, invested mainly by money market funds and wealthy individuals. Experts say that was the year when the muni bond market shifted away from its high-net-worth roots and began attracting interest from hedge funds and the proprietary trading desks of investment banks.
Insurers like Ambac and MBNA, whose coverage enabled many municipal bonds to earn triple-A ratings, saw their own ratings fall when the market for toxic mortgage-related debt, which they had also insured, imploded last year. As a result, they stopped insuring munis. Triple-A paper was quickly downgraded, forcing hedge funds, dealer banks and other large investors governed by strict mandates to dump their muni bonds. “That was what precipitated a full-scale collapse of the municipal bond market,” explains Thomas Doe, CEO of Municipal Market Advisors, a Concord, Massachusetts–based strategy and research company. “The same firms that the market relied on to provide liquidity became the sellers.”
This unraveling rattled the entire municipal financing system. But opportunistic buying by savvy investors like Buffett, a commitment by the Obama administration to spend as much as $850 billion on infrastructure over two years and proposed legislation to create a new federal agency to backstop municipal bonds have renewed confidence in an asset class that seemed doomed last fall. Further fueling the renewal is the Build America Bond program, introduced in April, which enables state and local governments to issue taxable paper for funding capital projects and receive a federal subsidy for their borrowing costs equal to 35 percent of the coupon paid. The program, which is part of the American Recovery and Reinvestment Act of 2009, had raised $13.8 billion by the end of May. “Municipal bonds are back to their pre-euphoria selves,” says Doe. “Between 2003 and 2007 the steepness of the municipal yield curve, combined with the predominance of insurance, allowed triple-A ratings and the funding of leveraged positions.”
Record spreads between muni and Treasury yields — although temporary — have been a major factor driving investor interest. Although municipal bonds usually yield less than Treasuries do, on December 18 the yield on a 30-year, triple-A callable muni was more than double that of a 30-year Treasury note, and a ten-year single-A muni was yielding 245 basis points more than a comparable Treasury, largely because of the oversupply caused by massive deleveraging in the market.
Enter the bargain hunters. In the nine months ended March 31, Berkshire Hathaway added more than $2 billion of munis to its portfolio, bringing its total in the category at the end of the period to $4.32 billion, the highest level in four years. “A few years ago it would have been unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds,” Buffett wrote to his shareholders in February. Other investors followed his lead.
Still, today’s municipal market is different from that of two years ago, says Cummings: “It has transitioned from a rates market to a credit market.” In other words, bond buyers currently evaluate potential purchases on their creditworthiness and select specific issues, in sharp contrast to considering all munis equally solid because of their insurance wrap.
“What you’re now seeing is a real municipal bond market,” says Hugh McGuirk, director of municipal investments at T. Rowe Price Associates, which currently has $12 billion in municipal bond assets in its various funds.
The sharp exit by hedge funds — which, along with the proprietary trading desks of banks such as Lehman Brothers Holdings and Bear Stearns Cos., accounted for nearly three quarters of muni trading volume by late 2007 — has shifted the focus to risk analysis, says McGuirk. In the early 2000s the new players boosted the volume of new issues to an average of $433 billion annually, up from $253 billion in the early 1990s, he notes. McGuirk expects the pace to slow this year but to remain in the range of $350 billion to $375 billion.
“We’re not out of the woods yet,” warns Pimco’s Cummings. “There is a greater liquidity premium, and credit quality is not as good as it was.” But he says the problems with alternatives — private equity and venture capital funds, which fail to deliver good returns — will drive investors into simpler instruments such as munis.
