Muniland – Muni Rally Lacks Quality

Year-to-date new municipal debt supply is down about 37.8% versus the same period last year.  The drop is driven largely by a 63.8% drop in refunding activity and a 57% fall in revenue bond issuance.  This lack of supply coupled with slightly positive weekly tax exempt mutual fund flows have driven front end MMD-to-Treasury ratios to become increasingly expensive.  Six months ago, the 5yr, 10yr and 20yr MMD-to-Treasuries ratios were about 93%, 104% and 117%, respectively.   As of last week 5yr, 10yr and 20yr MMD-to-Treasuries ratios were hovering around 65%, 89% and 101%, respectively.  Next week will test the true strength of this run in the muni market as investors will be asked to take down an estimated $11 billion in new issuance or 20% of cumulative YTD supply.  Deals include the much anticipated $3.0 billion in Puerto Rico debt to cover liquidity and operating shortfalls, $1.7 billion from the State of California for refunding currently outstanding debt, $1.3 billion Houston Combined Utility System debt, $400 million City of Chicago debt (just downgraded to Baa1 by Moody’s) and $400 million Illinois State Sales Tax backed bonds.  A seasonal increase in debt issuance is one of the components we were anticipating at the outset of this year to lead to better relative value in the municipal market.  Remember, in our note from early February we were looking for a combination of the following factors to generate volatility and cheapen the muni market: a credit event, municipal fund outflows and/or seasonal new issue supply.  Two of our three components are in place.  The market strength has felt “low quality” and seemed almost purely driven by lack of supply as buyers have had to fight for bonds by paying up and in the case of dealers who buy bonds they have at times struggled to turn over their new inventory; anecdotal evidence of this comes from our own trading, as we have sold various bonds to the street and watched those re-offers sit in inventory, waiting for a buyer.  We are looking forward to next week’s new supply and expect it to outweigh demand and weaken the market creating an opportunity to buy at better relative valuations.