by Calculated Risk on 11/19/2010 09:30:00 AM

From Bond Girl: Some thoughts on the muni market

I have been somewhat hesitant to write about the recent sharp correction in the muni market, mainly because I do not like wasting my time.
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My opinion, for whatever it is worth to you, is that there are a handful of factors – mostly unrelated to the relative creditworthiness of muni issuers – that have provoked this correction. These factors are related, and they will likely contribute to volatility going into next year. The first, obviously, is a supply glut. The pending expiration of the Build America Bond (BAB) program has pulled supply forward, and this is going to seesaw over the next several weeks. Since the BAB program was initiated, most issuers have structured their new issues with the sense that they will go to either the tax-exempt or taxable market, whichever is more advantageous at the time. It has been almost completely a supply management game since the market for these bonds was established and munis became truly bifurcated.
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By allowing muni issuers to sell taxable bonds, the BAB program opened the market up to investors like pensions and foreign investors, who otherwise would not benefit from a tax exemption on the interest income on the bonds and would find tax-exempt yields unappetizing. This program has relieved the supply pressure on the market for essentially two years now, keeping interest rates low.

What is going on now is that muni issuers are scrambling to get deals done to take advantage of the program before it expires, and this is pulling the number of new issues that would ordinarily be coming to market forward. So the looming expiration of the BAB program is creating the very conditions it was created to alleviate. Issuers are very conscious of this fact, and that is why a large number of deals are getting pulled. As more issues get pulled and supply is reduced, there will be some relief on rates, which I think is what happened today. But you can expect that muni issuers will be dancing around this until the program expires at the end of the year, so there will likely be significant volatility. There is also considerable uncertainty as to how supply issues will play out in the first quarter of 2011.

I think it is important to understand that these supply issues are what is driving the muni market - not an imminent default.