Summarizing The Recent Muni-Mauling, And A Look At The Challenges Ahead
The main reason why in a recent Zero Hedge poll the bulk of respondents believed that the next asset class to be purchased by the Fed are municipals, is that the market appears to have finally relented to what pretty much everyone with half a working brain has realized for over almost two years: the very soon, only the Fed's endless bid will be able to withstand the state and city default onslaught. Two main catalysts over the past week, as Zero Hedge highlighted last week, were the now imminent bankruptcy of Harrisburg, and the dramatic deterioration in California's fiscal situation. However, there are other far more important considerations that suddenly have led to a massive blow out in the muni curve, that made even the highly volatile action in the UST curve seem tame in comparison. Citigroup's George Friedlander summarizes the biggest risks to the muni space, of which the number one is the least surprising: what happens when the government removes its crutches... With the entire economy now expressly reliant on constant and endless support of every branch of the US government, as more and more austerity is priced in, assorted asset classes will start feeling the wrath of this long-forgotten concept known as risk. Munis are just the beginning.
Below is a summary of the most relevant recent changes in the muni market from a curve standpoint:
As the table shows, the difference in yield between 7-YR paper and 30-YR paper increased from 211bp to 239bp over the course of a single week, an unusually rapid change.
And the reasons per Citigroup:
In our view, the factors that led to the dramatic relative weakness of the long end of the yield curve, wider credit spreads and generally reduced liquidity were fairly well foretold in the concerns we have been discussing over the past several weeks:
Growing concerns that the BAB program might not be extended beyond the 12/31/10 sunset. As we have noted, the fate of BAB reauthorization appears to be closely tied to the likelihood that the Bush 2001/2003 tax cuts would be extended during the lame duck session. If a deal can be reached between the administration and the newly invigorated Republicans in the Senate and the House on the Bush tax cuts, then a reauthorization of BABs is likely to be part of the deal – most likely, the 1-YR extension with a 32% subsidy contained in Senator Baucus' "mini-extender" bill. However, at this point, it is very difficult to tell whether a deal regarding the tax cuts will be reached. If such an agreement is not reached, new legislation will have to be drafted during the new Congress, and it is far from clear that a Republican-dominated House Ways and Means Committee will support an extension of BABs.
Concerns regarding other muni provisions in the stimulus bill that need to be reauthorized. In addition to BABs, there are four other significant sections of the stimulus package that are included in the Baucus bill but whose fate remains unclear, either in the lame duck period or in the new Congress.
1. The exemption of private activity bonds from the alternative minimum tax on individuals and corporations,
2. The exemption of all munis issued in 2009-10 from the Adjusted Current Earnings AMT on property and casualty companies,
3. The increase in the maximum amount of bank-qualified tax-exempts per "small issuer" from $10 million per year to $30 million per year, and
4. The 2% de minimis, under which commercial banks can buy munis worth up to 2% of total assets and still write off as an expense the interest cost associated with carrying these bonds.
At this point, it appears that, in terms of market impact, because of the lack of certainty regarding extension of the sunsets, the factor among these four that is having the greatest affect on the market is the exemption from the AMT for private activity bonds. The reason is this: issuers, such as airports, recognize that their borrowing costs would increase appreciably if interest on their bonds were once again subject to the AMT, so several airport issues are being rushed into the market to avoid the 12/31/10 sunset. Since private activity bonds, such as airports, ports and housing bonds, do not qualify for BAB treatment, these issues contain a significant amount of long-term tax-exempt supply.
An ongoing heavy new issue calendar, which is unlikely to let up. According to The Bond Buyer, the 30-day visible supply on Friday, 11/12, is $17.3 billion, only slightly below the high for 2010 of $18.7 billion, reached on September 28. It seems likely, in addition, that the new issue calendar will remain heavy right through the middle of December, when heavy supply can be particularly difficult to place. This could particularly be the case if bond fund flows continue to be weak, as noted next.
Continued weak flows into tax-exempt bond funds. For the week ending 10/3/10, tax-exempt bond fund flows were extremely weak, according to Lipper/AMG Data, with weekly reporting funds having less than $1 million in total inflows and long-term funds showing outflows of $178 million. This week's reported flows were only very slightly better, with all weekly reporting funds showing inflows of $42 million and long-term funds showing outflows of $33 million. With monthly reporting fund flows included, the four-week moving average of all funds is at $392 million, still down very sharply from the $1 billion range reported in most of July and August. Our greater concern is that next week's flows will probably be worse still. As we have noted, flows tend to weaken after a significant increase in muni market yields. As noted above, the increase in long-term yields in the muni market from 10/3 to 10/10 was quite substantial. And, indeed, a large proportion of the increase occurred during the last two days of the period, which does not bode well for flows over the next week.
In terms of pricing patterns, we note that stronger, more liquid BABs have held up well relative both to tax-exempts and to similarly rated corporates. We do not find this at all surprising. In the event that BABs are not reauthorized, we expect the best, most liquid BAB issues already in the market place will continue to outperform as supply dwindles. Initially, other less liquid BABs may weaken under these circumstances, but even in these cases, we expect the supply of outstanding BAB paper to dry up, with most of that paper absorbed by individual investors in the secondary market.
Another topic that has gotten little attention is Ambac's bankruptcy w/r/t muni exposure:
On Monday, November 8, the holding company parent of Ambac Assurance Corporation, Ambac Financial Group, filed for bankruptcy. In our view, this move was not unexpected, given the firms inability to write new policies or maintain minimum capital requirements. Nevertheless, we do not believe that this move gives the insurance subsidiary the ability to continue to make payments on insured municipal obligations at this point. The company has initiated a "rehabilitation proceeding" in order to protect the majority of policies related to municipal debt.
Back in March, the Office of the Commissioner of Insurance of the State of Wisconsin (OCI) approved the establishment by AAC of a segregated account containing certain non-performing policies, primarily consisting of structured products transactions, including Residential Mortgage-Backed Securities. The Las Vegas Monorail was also placed in the segregated account. The rehabilitation of the structured book is intended to shield policyholders of AAC from ongoing losses in the structured book. While the proceeding is subject to court approval as well as ongoing litigation, in our view, the insurer currently has the capacity to continue to make payments on policies for defaulted municipal issues not included in the segregated account, which includes nearly all municipal bonds.
We note that the muni market continues to give very little extra pricing value on Ambac-insured munis over what they would be worth as uninsured issues. Nevertheless, particularly on Ambac-insured muni credits with very weak underlying credit strength, we believe that the existence of the insurance policy significantly enhances the value of the bonds.
Lastly, a topic that has gotten much attention recently, and which is what lead the mainstream to realize that muni spreads and the MCDX were surging, has to do with ETFs. Of course, using the recent plunge in assorted synthetics, Citi uses the opportunity to present this as an ETF buying signal. We, on the other hand would recommend a convergence pair trade, as as sell off in intrinsics is just as likely, as in our extremely correlated markets, ETFs traditionally are the primary negative convexity catalyst, after which all other asset classes follow. For the past two years this has been to the upside. It can just as easily happen in the opposite direction...
In the last several days, we have seen an unusual move in muni ETFs. Prices of several dropped by more than 2% in the last several days – an unusually large move for this ETF product. Given where several of the ETFs are trading at the moment, their NAVs are at the largest discounts to the current prices in a long time. In our view, the move of the ETFs was too abrupt and strong to account for the weaker price action of long-dated muni tax-exempt market. Keep in mind that the average life of some ETFs is just 15 years, so they should have been partially insulated from the large move of the 30-YR munis. In our view, this selloff is technical in nature and should be taken advantage of.
Since the near-term outlook for tax-exempts is somewhat cloudy, investors should take advantage of the ETF selloff by averaging down into the weakening market. Alternatively, they could hedge their exposure by shorting MMD against their ETF positions. To match maturity exactly, one could either use 15- YR MMD or, consistent with our steepener recommendation, one should short the 30-YR MMD.
When all is said and done, it would seem that the bulk of the risk in the muni space is not one of monetary intervention requirements, despite various markets going bidless, but of regulatory concern. And since Congress will not allow states to go bankrupt, now that Citi has raised the strawman that it will the House's fault should there be no improvement, it is only a mater of time before the whole BAB issue is resolved. That said, with every successive can kicking, the time to the inevitable market test approaches. However, unlike our readership, we believe that the Fed will actually preserve its last bit of backstop purchasing dry powder for something much more important: the securitized markets, which are materially greater than the muni markets by, and whose fate will have an immediate impact not so much on assorted municipalities, than on the core of Bernanke's electoral constituency itself: Wall Street's TBTFs. After all, recall that QE works only to address a liquidity crunch (as the Fed become a buyer of only resort, and nothing more), which is why it will do nothing to ameliorate the current increasing solvency problems. Only when solvency risks metastasize into the realm of liquidity once again, that is when the time to panic will be nigh.