The tax-exempt market has entered the final stages of the weak technical environment that resulted from the tax-filing season that ends on April 15th. Supply/demand imbalances have typically developed during this period as investors raise cash in the tax-exempt market to make tax payments, while new issue supply has traditionally been very heavy in March. This year was true to form, as selling flows were heavy over the last three weeks and tax-exempt new issuance for March came in at $26.7 billion ($40.5 billion total municipal issuance), after averaging only $18.5 billion during the first two months of the year.
The weak technical environment, combined with low reinvestment flows from the proceeds of coupons/calls/maturities, resulted in yields rising in maturities from 5 to 10 years by over 27 to 38 basis points (bps) over a two week period from 3-15-10 to 3-31-10. Municipals also drastically underperformed Treasuries during this period, with tax-adjusted spreads to Treasuries widening by 25 to 36 bps from 3 to 10 years. Anticipating this weaker relative-performance development, we were active crossover sellers of tax-exempts during the first week of March.
Since the end of March, municipals have continued to experience a modestly weaker tone, but the market has stemmed the selling flows and a better relative-valuation profile to Treasuries has started to attract buyers. Additionally, with the demand for Build America taxable municipal bonds surging, solid “AA”-rated credits in the taxable space are trading at spread levels versus Treasuries that are well-through duration-comparable “AA”-rated tax-exempts 10 yrs and longer.
Consequently, the tax-exempt market looks very attractive relative to their taxable counterparts in this maturity range, and a concerted effort should be made for crossover accounts to swap solid “AA”-rated taxable credits for similar credits in tax-exempts. One example of this trade is to sell taxable Dallas Transportation Build America bonds in 30 years at 90 bps spread to the 30 year Treasury in exchange for tax-exempt Dallas Transportation bonds in 21 years at 197 bps tax-adjusted spread to the interpolated Treasury curve. This trade picks up approximately 71 bps in absolute yield and an additional 107 bps on a curve-spread basis.
The outlook for the tax-exempt market continues to look positive over the long-term as a favorable technical backdrop provides for a yield curve flattening bias. The funding levels available for issuing debt in the taxable market using the Build America 35% subsidy remains dramatically lower than what issuers are able to garner from issuing long-term debt in the tax-exempt market. Consequently, taxable issuance will continue to supplant long-term tax-exempt issuance and provide a build in scarcity value for tax-exempt bonds 10 years and longer. With the expiration of the Bush tax cuts after 2010, which will result in the highest tax bracket increasing from 35% to 39.6%, there should also be an increase in demand from the wealthy. This additional demand should provide additional pressure for yields to recede and another compelling reason for longer-term tax-exempts to outperform the taxable market.
Gregory A. Bell, CFA, CPA
Director of Municipal Products
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