Despite the 'idiosyncratic' stresses in California (and elsewhere) the reach-for-'safe'-yield has maintained a strong bid for Munis in the last few weeks (on both a spread and yield basis). As Citi's George Friedlander notes, the last week alone saw 15-20bps compression in the mid- to long-end of the Muni curve - notably outperforming the longer-end of the Treasury curve. New issues have been oversubscribed and snapped as much as 20bps on the break. The reason is simple - 'all-time record' total redemptions (maturing and called bonds) - which left net issuance negative and a strong tendency for certain types of investors to put cash back to work as soon as it is received. However, this flood of 'technical' liquidity from reinvestment faces a rather sudden cliff around the start of August when expected net issuance will turn aggressively positive relative to redemptions. Given the constant refinancings and a lack of maturing reinvestment, Freiedlander expects "the muni market to struggle to absorb [the heavy calendar] after August 1 - and slightly earlier if participants begin to discount this shift", which will only push refinancing costs higher for issuers coming to market.
George Friedlander, Citigroup: Will the Muni market be held to ransom to slowing bond redemptions?
We believe that the strong rally resulted from a number of factors including:
- The ongoing powerful bond call/maturity peak which runs from June 1 though August 1, as shown in Figure 4. Note that redemptions occurring on the first of a given month are shown as if they occur in the prior month. More about this below.
- A strong tendency among certain types of investors is to put cash back to work as it is received. In particular, this has increased demand from bond funds and separately managed accounts. In both of these sectors, proceeds from redemptions tend to be put back to work rather quickly because cash that lies fallow at near-zero yields affects yields reported to investors. Bond funds in particular tend to hold on to high-coupon paper purchased when yields were higher as long as they can, in order to maintain reported yields. Then when those bonds are called, they have cash to invest. This pattern, combined with the massive amount of bonds being called as shown in the table, has led to bond funds being participants in new issues at a multiple of the $800 million — $1 billion that has been flowing into bond funds (4-week moving average of all funds) over the past two months.
- A calendar that remains solid, but is not nearly back to June levels. June saw roughly $44 billion in issuance, a rate of roughly $10 billion per week. Now,issuance appears to be in the $5 1/2-$7 billion range, at least for now.
- The "hole" in primary and secondary supply created by the 4th of July week hiatus. New issuance was close to zero for that week, and we suspect that a number of dealers attempted to reduce secondary market inventory as well, in order to avoid taking market risk when markets were virtually closed.
- Better price discovery as new issuance returned. The muni market has a tendency to underperform its fundamentals when price discovery becomes difficult, as it was during the holiday week; and
- Quite simply, the tug of the ongoing Treasury rally, which put yields on 10-year and 30-year paper at new closing lows for this long down cycle.
What Happens When the Redemption Music Stops?
Historically, redemptions have always clustered around coupon payment dates, in a three-month on/three month off cycle, around the months when coupon payments are at their highest: December 1, January 1, and February 1 and then June 1, July 1, and August 1. In the intervening months, redemptions from bond calls and maturities drop sharply.
Muni Bond Call and Maturity Patterns
As we show in the chart above, the magnitude of total redemptions from maturities on bond calls spiked beginning in May (which includes June 1), and stayed high for the next two months. Over that three-month period, net new issuance remains substantially negative, despite a strong pickup in new issue supply. After that, the typical dry spell begins, with total redemptions dropping from the $48–$50 billion range to roughly $21 billion in August (minus the August 1 proceeds, which show in the prior month in all cases). We anticipate that the subsequent two months will be no better, although data are not yet available. As a consequence, net new issuance turns substantially positive despite an expected modest decline in gross supply. More importantly:
- The importance of redemptions as a source of demand for new issues has never been higher, with total redemptions during the current peak three-month period at levels we believe to be an all-time record by a wide amount. A big spike in current and near-current refundings during the current low-rate environment has contributed heavily to this pattern.
- We expect total redemptions to stay sharply lower for the next three months as they always do in the three-month period after August 1.
- We thus expect the investor sectors that tend to put cash back to work quickly as bonds are redeemed — funds, SMAs, and some direct retail — to have far less cash to put to work until the next up-cycle in redemptions begins, which is on December 1.
These two patterns, in our view, are likely to create a new challenge for the muni market if new issuance stays high, as we anticipate. New issue volume is being held at very high levels by current and near-current refundings (in a cycle that we expect to last until at least 2015 unless muni yields spike higher to a degree that seems unlikely). As a consequence, net new supply should move well into positive territory for the period August–October, before turning negative again as redemptions spike. At the same time, of course, the sectors that typically pour cash back into the market as redemptions spike will have far less new cash to put to work.
The bottom line of all this is that we expect the muni market to struggle to absorb a continuing heavy calendar beginning at some point after August 1, and possibly slightly earlier if participants begin to discount this shift. There is, of course, both bad news and good news in this. The bad news is that valuations of existing holdings could come under pressure, and issuers could face a somewhat higher cost of financing. The good news is that the large number of investors who have become increasingly frustrated by the continuing decline in muni yields may experience a respite from that decline, and possibly even a reversal of the drop in credit spreads between gilt-edged and upper-medium-quality paper noted above. In any event, we believe that investors should be on the lookout for better values once the drop in redemptions begins in earnest.