MUNI OUTLOOK June 2005 Municipal Market Advisors www.mma-research.com 978.287.0014 75 Main Street Concord MA 01742 Focus on Leverage in the Municipal Market and Change in the Industry June was defined by sharp price swings and attention to the amount of leverage in the financial system particularly tax-exempts. 2005 has been defined by the aggressive education of municipal issuers, investors and dealers to the opportunities and flexibility associated with derivative products and leveraged strategies. The increased flow of assets into municipal hedge funds, development of more aggressive proprietary desks and increased use of swaps by issuers has resulted in a rapid change within the municipal industry. This year has squarely marked the departure of the industry from one characterized by the placement of product with investors to a trading market. While daily activity has been defined by the new participants and business models, the largest amount of assets remain under the domain of those with a traditional perspective towards tax-exempt product. The direct impact on the municipal industry has created a bifurcated condition. A relatively small percentage of transactions represent the majority of par value traded daily. The larger trades at aggressive prices are conducted by a small percent of participating firms and yet dictate the evaluations and pricing of held assets and tangetial derivative products. Most notable is the growing dependency on arbitrage Performance Municipal Performance Favorable in July 6% 4% 2% 0% -2% -4% -6% -8% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 Figure 1: July Municipal Performance 1990-2004 accounts as defacto exchanges to provide liquidity. The importance of these flexible accounts cannot be underscored enough as they provide access to product and a bid for a variety of municipal issues for dealers and investors alike. The end of June called further attention to the presence and growth of municipal hedge funds, or leveraged tender option bond programs. The coverage of the product in The Wall Street Journal s Heard on the Street column signified the important role that leverage plays in the creation of both short-term cash equivalent product and attractive investment alternatives to high net worth accounts. In June 2004 the $10B Illinois taxable POB issue captured foreign investor attention for its yield and soveriegn-like credit quality. The awareness of the municipal market s credit attributes and returns from a steep yield curve has enhanced the broader distribution of municipals. Without the emergence of the new products in the municipal market it is arguable whether US states and municipalities would have enjoyed the successful distribution of record supply at historic low yields over the past three years. Municipal participants have sought to undertsand where the risk is to the industry from the dependency on leverage and arbitrage accounts. The growth of municipal leverage funds is analagous to the fast evolution of municipal bond mutual funds in the 1980 s. Similarly, funds became a preferred customer and by 1991 were cast by some in a villanous light. In 1986, 1987 and 1994 significant investor outflows created severe shocks to the industry. However, while painful, they were only shocks and the products evolved and continued to attract assets. Hedge fund redemptions and closures attracted headlines in June after Federal Reserve s Chairman Greenspan s remarks and wide disclosure of hedge fund losses in 2005. For example, Vega Asset Management cited $400M in May redemptions and a decline of 2005 assets by $3B as fixed-income losses mounted. Municipals Reflect Value on June 30 Similar to the end of May, the municipal market reflected value on a relative basis to the Treasury market. The 5-year, 10-year and 30-year ratios were 81.4%, 90.3% and 106.9% at month-end. The 30-year ratio is the highest since 1986. The 10-year ratio above 90.0% signifies a level that has historically been attractive to crossover trading accounts. The 10-year ratio s standard deviation is also 1.5, a level indicative of the
swiftness of the ratio s change. The relative value of the municipal sector is also represented in the BMA and Libor swap ratios. Figure 2 illustrates the near maximum levels of the relationships of the swap ratios for nearly each spot maturity of the curve. Similar to the cash market relationship, the 10-year ratio is 1.14 standard deviations above the mean reflective of the speed with which the relationship changed at month-end. Increased attention to the relative relationships is indicative of to the municipal industry s inclusion in the broader fixed-income trading dynamics. The shift in the ratios is largely attributed to the varying degree of sensitivity and responsiveness in different market conditions. Figure 3 illustrates the historical relationship of the municipal and Treasury cash markets by comparing the 20-day daily average of the absolute value of each markets price change. The Treasury price change has not fallen below 0.40% in the past 12 months. In June, volatility increased to 0.70%. In ABS Price Change 1pt=1% Figure 3: Treasury volatility far greater than the municipal market and creates ratio opportunity Swap Ratio 0.80 0.60 0.40 0.20 Figure 4: Ratios closed near their 12-month highs at the end of June Maturity Consensus BMA LIBOR Treasury % to Trsry # of SD Prev Day BP Chng 06/23/05 06/06/05 06/30/04 1yr 2.64 2.74 3.89 3.43 77.0% -1.4 2.65-1 2.65 2.69 1.58 2yr 2.70 2.91 3.98 3.63 74.4% -1.3 2.71-1 2.71 2.74 2.10 5yr 3.01 3.13 4.12 3.70 81.4% 1.1 3.02-1 3.02 3.02 3.17 10yr 3.54 3.39 4.34 3.92 90.3% 1.5 3.56-2 3.55 3.56 4.04 15yr 3.89 3.60 4.50 n/a n/a n/a 3.91-2 3.90 3.91 4.53 20yr 4.19 3.72 4.58 n/a n/a n/a 4.20-1 4.19 4.19 4.88 30yr 4.48 3.80 4.63 4.19 106.9% 2.1 4.50-2 4.49 4.48 5.08 Past 60 Trading Days Past 60 Trading Days Past 60 Trading Days Maturity % to Libor # of SD Max Min BMA vs. (bp) # of SD Max Min BMA /Libor % # of SD Max Min 1yr 67.9% -1.33 72.8% 66.8% 10 0.52 17 2 70.4% -1.60 74.7% 70.4% 2yr 67.8% -0.76 71.3% 65.9% 21 1.65 22 6 73.1% 1.21 73.2% 70.9% 5yr 73.1% 0.95 74.5% 69.7% 12 0.24 18 3 76.0% 1.66 76.0% 73.6% 10yr 81.6% 1.17 82.8% 77.4% -15-0.77-5 -20 78.1% 1.14 78.4% 76.4% 15yr 86.4% 1.43 86.7% 81.1% -29-1.06-14 -32 80.0% 1.64 80.1% 78.3% 20yr 91.5% 1.80 91.5% 85.3% -47-1.62-31 -47 81.2% 1.78 81.3% 79.3% 30yr 96.8% 1.73 96.8% 90.0% -68-1.74-50 -68 82.1% 1.53 82.2% 80.3% Figure 2: The Treasury rally on June 30 created a condition where municipal cash and BMA swap appeared attractive to Treasury and Libor rates respectively contrast, the municipal daily change has rarely, and only slightly, risen above 0.20%. The difference in the two markets and therefore their respective derivative products highlights the on-going opportunity created by the significant variance in volatility. Figure 4 provides a 12-month snapshot of the 10-year ratios for both the cash and swap curves. Both sectors ratios ended June not only at their 60-day maximum levels but Relative Price Volatility: Treasury v. Municipal Cash 0.00 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 79.0% 78.0% 77.0% 76.0% 75.0% 20-day Average (T) 20-day Average (M) Cash Ratio v. Swap Ratio 10-year: Past 12 Months 74.0% Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 BMA%Libor Muni%Treasury 92.0% 90.0% 88.0% 86.0% 84.0% 82.0% Cash Ratio also near the highest percentages attained over the past year. The swap ratio was near the November 2004 and April 2005 peaks, while the cash ratios were near levels attained on June 1. BMA Low Yields Promotes Refundings Figure 2 also compares the BMA fixed swap rate (provided by Prebon) to the municipal cash yield. The lower level of the BMA fixed rate allows for the attractive conditions for investors to issue floating rate debt and swap it for a synthetic fixed rate. As suggested by the low BMA level (nearly 50 basis points in the 20- year maturity), there is a great deal of advantage in the synthetic refunding opportunities. Despite the attractiveness of the BMA relationship, issuers have also sought the traditional route of access to the capital markets. In June more than $40B municipals were issued, increasing the 6-month total to more than $205B a new record. The closely watched 4- month average rose to $152B, just shy of the record established in 2003. The rolling 12-month total increased to $375B, the highest since the end of May 2004. The demand from tender option bond programs for AAA and AAA insured debt continued to generate significant historical spread distortion in the longer maturities of competitive new issues as well as an increase in percentage of new issues carrying insurance in 2005, 59.9%, a record pace. Figure 5 compares the 4- month and 12-month moving totals of municipal issuance and highlights the steadiness of issuance in recent years. The stability of high debt sales deviates 2
from the history of the past 17 years when peaks to record issuance were followed by a reduced need for debt and therefore a period of low tax-exempt annual volume. A possibility is that issuers greater comfort with debt management and the utilization of the swap products over the past 3 years, combined with a sluggish US economic recovery, has enabled issuance to remain vibrant. 4-Mo Total ($B) Municipal Bond Issuance: 1988-2005 $180 $150 $120 $90 $60 $30 $0 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Issuance 4-mo Issuance 12-mo $450 $380 $310 $240 $170 $100 $30 12-Mo Total ($B) Figures 6 and 7 highlight the advantage that the shorter maturities provided in June. Inside 10-year there was virtually little change in either yield or price. While in the longer maturities, the 2 to 3 basis point change produced price losses in excess of 0.40% beyond 25-years on the curve. The transactions in the front of the yield curve increased noticeably beginning on June 17. Numerous sessions reflected a larger amount of customer buying activity in the shorter maturities - between 0 and 5 years. Price Change 0.2 0.0-0.2-0.4-0.6 Figure 5: 12 month and 4 month issuance totals near the 2003 peaks Figure 6: Municipal yields change was stable with reward in the front of the curve Summary: Slope and Ratios The historical summaries of both the curve and ratios (municipal v. Treasury yields) are provided for key maturities in Figures 8 and 9. Figure 8 provides a reminder of the steep slope of the municipal curve of 1 and 3 years ago that contributed to the keen interest in the leveraged municipal programs which in turn Municipal Consensus Yields - Current vs. 1mo. Prior & Price Change 5.75 4.75 3.75 2.75 1.75 0.75 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 40 Maturity 1-Month 6/2/05 6/30/05 Figure 7: Inside 10-years there was minimal change while the long-end suffered with 0.40% loss Basis Points 350 300 250 200 150 100 50 0 304299 Basis Point Spread Between Maturities: Current, 1, & 3 Years Change (bps) 4 2 0-2 -4-6 178 194192 110 84 107 94 104106 90 86 55 49 55 58 31 53 35 59 2-30yr 2-10yr 10-30yr 2-5yr 5-10yr 10-15yr 15-30yr 3-Year Ago 1-Year Ago Current Figure 8: The municipal curve flattening in the past 12 months has been dramatic Municipal Consensus Yield - Current vs. 1mo. Prior & Change 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 40 Maturity 1-Month Chg 6/2/05 6/30/05 Consensus Yield 5.75 4.75 3.75 2.75 1.75 0.75 Consensus Yield (%) have helped spawn municipal hedge fund growth. The 2 to 30-year basis point spread was consistently near or in excess of 300. In the past year, the FOMC s 9 interest rate increases have helped to flatten the curve inside 15 years. Specifically, the 2 to 5 year spread has flattened from 106 to 31 basis points, and the 5 to 10-year difference has narrowed from 86 to 53 basis points. The advent of new trading strategies has also increased the attention on the swap curves, specifically the relationship of BMA fixed swap rates versus the BMA 7- day floating rate index. The latter plummeted to nearly 2.00% in June after the estimated $57B municipal reinvestment funds impacted the money market funds and short-term cash instruments. The sharp drop in June demonstrated the volatility and seasonality of the BMA short-term rate. Nonetheless, the activity of the US Federal Reserve did apply an upward pressure on the BMA floating rate and as a result, the BMA 7-day to BMA 20-year fixed rate slope has flattened in 2005 from 259 to 147 basis points. In early June the difference was as little as 118. While short-term rates have risen, the movement to lower yields 3
has produced a relative cheapening of the tax-exempt product to Treasuries and other taxable comparisons. The snapshot of ratios at the end of June for periods ending 6 months, 1 year and 3 years ago reflect the greatest cheapening in the intermediate and long maturities. The 10-year ratio rose above 91.0% at the start of June to draw aggressive crossover participation, and a similar relationship was attained at the end of the month. Recently, a breach of the 90.0% ratio has yielded a sharp and powerful rise in Treasury yields. The 30-year maturity s ratio has risen to levels in 2005 that have not been attained since 1986 (the period prior to the implementation of taxreform, and related issuance curbs). The high ratio emerged in February and has persisted as the demand for the scarce Treasury 30-year bonds by US pension and global investors has intensified. The prospective return of the Treasury 30- year in 2006 (to be determined in August 2005) could contribute to restoring the ratios to more historically average relationships. Fundamentals: Central Banks Dominate June s bond market activity was greatly influenced by the activity and comments Price (32nds) Ratio (%) Municipal Consensus as a % of Treasury Yields: Current, 6 Month, & 1 Year 110% 100% 90% 80% 70% 60% 105% 94% 96% 97% 84% 85% 88% 85% 88% 77% 77% 77% 78% 79% 77% 79% Figure 9: The rise in intermediate and long-term ratios is consistent with strong bond rallies from Federal Reserve officials as well as activity by European central banks. Figure 10 illustrates the days when bond market price change was greatest. The monthly manufacturing data was reflec- Figure 11: The Sep05 Treasury 10-year support has been between 113-10 and 113-13. A break below the range suggests next support is 112-20 to 112-23, below which there is an absence of volume. Yield (%) 114.13 113.18 112.30 112.10 111.21 110.30 5.0 4.5 4.0 3.5 10yr T-Note Market Distribution: May, 1 - June, 30 September Contract Price 1yr 5yr 10yr 30yr 4 3-Year Ago 1-Year Ago 6-Month Ago Current Date Economic Indicators/Fundametal Events Survey Actual Muni Change Treasury Change 6/1/2005 ISM 52.0 51.4 0.49 1.86 6/3/2005 Non-farm 175k 78k -0.26-0.84 6/7/2005 Fed's Greenspan Speech na na 0.31 1.02 6/10/2005 US Trade Deficit -$58B -$57B -0.32-1.51 6/13/2005 Fed's Santomero Speech na na -0.30-0.83 6/14/2005 Fed's Lacker Speech na na -0.21-0.83 6/21/2005 Sweden's Riksbank cut rate na na 0.30 0.84 6/22/2005 BOE - 2 policy makers vote for rate cut na na 0.52 1.52 6/28/2005 Consumer Confidence 104.0 105.8-0.31-0.84 6/30/2005 Chicago PM 54.0 53.6 0.18 1.19 6/30/2005 FOMC increased rates 3.25 3.25 Relative Volume 15yr Municipal Consensus and 10-yr Treasury Yield January 1, 2003 - June 29, 2005 3.0 Jan-03 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Mar-05 15yr Municipal Figure 12: Municipal 15-year and Treasury 10-year closed below 4.00% at the end of June Figure 10: Volatility in bond prices was most often associated with central bank activity and comments 10yr Treasury Yield 5.0 4.5 4.0 3.5 3.0 Yield (%) tive of US economic weakness. The ISM data for May was below expectations as was June s Chicago Purchasing Managers report at month-end. While the Federal Reserve Chairman s remarks lent support to the bond markets, follow-up comments from Federal Reserve Regional Presidents Santomero, Stern and Lacker, as well as Federal Reserve Governor Kohn reiterated intentions that the FOMC was inclined to continue to increase short-term interest rates. The appearance of US value to global investors occurred when Sweden s Riksbank cut rates. The next day, two policy makers of the Bank of England voted to reduce rates which further fueled speculation of a slowing European economy and bolstered the US bond market. There also emerged a growing consensus that the Federal Reserve was focused on the removal of leverage from the investment and real estate markets. However, that conjecture aside, the increase in both the monthly Consumer Confidence data 105.8 v. est. 104, and the improvement in the preliminary University of Michigan sentiment report 94.8 v. est. 88.8 was sufficient to lend support to an improving US economy and potentially higher yields. However, early in the month, both Leh-
man and Morgan Stanley reduced their projections for 2nd qtr. growth. The ambiguity in the economic data and forecasts was truly revealed when the lowerthan-expected non-farm payroll did not elicit the sustained rally normally associated with lower than expected data. Technically: Treasury 10-year Support at December 2004 and February 2005 Highs The Sep05 Treasury 10-year future built considerable volume in the area where in December 2004 and February 2005 new highs were attained. The range between 113-10 and 113-13 became pivotal to the contract during June. At the end of June, the contract closed in the vicinity of the range after attracting supportive bids on brief declines below the area. Should the contract fail in July to garner a supportive price response on declines, then the next area, defined by trading volume is 112-20 to 112-23, Figure 11. Should the contract not hold in this range, there is a potential for a greater decline similar to February and March. As June closed, not only was the municipal Consensus Price Index nearing a bearish condition but also volatility in the Treasury market had increased markedly. Higher volatility in the past year has occurred in both rallying and bearish conditions as well as coinciding with the end of the last three quarters when compensation strategies could be linked to transactions by hedge funds and leveraged accounts. With both the Municipal 15-year and Treasury 10-year below 4.00% yield the tenuous conditions at month end adopted a greater degree of significance, Figure 12. CONTACT INFORMATION: Municipal Market Advisors 75 Main Street Concord, MA 01742 978-287-0014 (T) 978-371-2064 (F) www.mma-research.com 5