by Brian Reilly, Financial Advisor
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Municipal issuers continue to enjoy access to capital at attractive rates. Competitive offerings of both tax-exempts and taxables are finding a wide audience. There are signs this may change. Now may be an opportune time to expedite financing of capital projects.
Interest rates across multiple market segments remained quite stable through mid-March of this year. However, the last few weeks of the quarter have seen some rather rapid increases across all points of the yield curve.
Treasury yields have been under pressure (i.e. rising) as a large supply has recently been absorbed and a number of auctions have seen lackluster interest from both domestic and foreign purchasers. The yield on the 2-yr. Note has risen roughly 25 basis points (0.80% - 1.05%) since the end of February, while 10-yr. Note yields are up about the same amount in that time, reaching levels last seen in the summer of 2009.
The Search for Returns and the Rise of BABs
While Treasury rates have indeed risen, they are still low on an absolute basis, and it would seem as though
fixed income investors are once again shedding their risk aversion and "reaching" for yield. Spreads on
corporate bonds have tightened over this time to levels that are commensurate with those seen prior to the
collapse of Lehman Brothers and the general credit "crisis" that ensued. This improvement in corporate
borrowing rates has come in spite of heavy issuance in both investment grade and high-yield markets.
We see the spill-over effects of these phenomena in the municipal market, as well. Tax-exempt muni's are trading at ratios to treasuries that are quite low by historical standards. The typical ratio for tax-exempt to treasury yields has been in the 80% - 85% range, while Municipal Market Advisors reports ratios of 75% and under through seven years, and around 80% at ten years. Additionally, the supply of taxable muni's is expanding as a result of the Build America Bonds (BABs) program and long-term investors desire to obtain yield and diversify away from U.S. government and corporate bond holdings. With the lack of other taxable investment product due to decreased issuance, taxable muni's have found a welcome audience. BABs accounted for almost 16% of total municipal supply in CY 2009 (the first BABs issues were brought to market in April of 2009), but have accounted for almost 25% of supply for January and February of this year. We can anecdotally suggest that this trend is likely to increase for the month of March, as many of our clients have utilized direct-pay BABs as a more efficient borrowing method versus traditional tax-exempt structures.
There is currently a bill before the President that would expand the use of BABs and reauthorize the program through the end of 2013 (current authorization ends Dec. 31, 2010). The federal subsidy would diminish until such time as it reaches 30%. Recent experience indicates that BABs would still provide value to issuers at the 30% rebate level, but, under current market conditions, would provide only limited benefit over the tax-exempt alternative.
The Fed's Change in Stance
The Federal Open Market Committee (FOMC) met the week of March 15th and reiterated its posture towards maintaining an accommodative
monetary policy - - that is, keeping its target for the Federal Funds rate in 0 - 25 basis point (bp) range. That being said, we
seem to be at somewhat of an inflection point with regard to monetary policy. For some time, the effective Federal Funds rate was
in the 10 - 15 bp range, but has most recently moved into the 15 - 20 bp range. The Fed raised its rate available to institutions
that access the discount window, which is typically referred to as the "penalty" rate in late February.
Furthermore, March marks the end of the Federal Reserve's venture into outright purchases of mortgage securities, which amounted to roughly $1.5 trillion in asset purchases during that program's tenure. The Fed has also announced the winding down of other programs that were instituted at the height of financial market collapse. The Fed appears to be slowly, but surely, dismantling its backstops for capital markets and stealthily removing monetary stimulus. The next step would be a more concrete shift towards an increase in the federal funds rate, or even outright sales from its accumulated portfolio. This reduction in the Fed's balance sheet and shift in monetary policy may have the effect of raising general levels of interest rates as money is taken out of the system, but, that is a big "if." Given the amount of Federal Reserve and government intervention across many markets and sectors, the typical dictums of the past are bound to provide less direction for this cycle.
What Does It All Mean to You
For now, municipal issuers are still enjoying access to capital at attractive rates. Competitive offerings of both tax-exempts
and taxables are finding a wide audience, even without the participation of credit enhancement through bond insurance. Yes, rates
have generally increased the past few weeks. This has had the effect of eliminating some taxable and tax-exempt refunding
opportunities, but should not discourage plans for raising new money. One may even read the tea leaves to mean that capital raising
efforts should be expedited given some of the likely headwinds outlined above.
