Municipal Bonds Storm Back

The problems seen in the last few weeks disappear.
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Municipal-bond yields are falling fast after hitting record highs vs. Treasury bonds on Friday.

Late last week, municipal arbitrage funds were being hit with margin calls, as their hedges were rapidly moving against them. This lead to billions of dollars in forced selling, which when pushed on the relatively illiquid municipal market, caused prices to plummet. On Friday, high-quality municipals were widely available at spreads of 100bps or more above Treasury rates. Typically, municipals yield about 80% of Treasury rates.

Initially, word on the street was that these historic levels were enticing hedge funds and other non-traditional muni buyers (even Bill Gross) to buy tax-exempt munis. This was good news and bad news, of course. The good news was that it meant that there was, indeed, capital in the system to ensure that the muni market would clear.

The bad news was that these non-traditional buyers would only be around as long as muni prices were stupid cheap. In other words, this was fast money, and fast money never sparks a persistent rally. Fast money is always looking to take its profit and get out. At best, these non-traditional buyers would merely prevent the muni market from going lower still.

But the initial read was apparently wrong. On Monday, retail buyers (i.e., mom and pop investors) started coming out of the woodwork to buy bonds. The State of California came with a $1.7 billion deal on Monday. Demand was so strong that the underwriter cut the interest rate by 15 basis points across the board, and still $1 billion of the deal was done retail.

Now maybe there has been a $1 billion deal done retail in the past, but I sure don't remember ever hearing of such a thing. Smith Barney, Citigroup's retail brokerage arm, supposedly had the best day for selling municipal bonds in their entire history on Monday. One large dealer I talk to regularly said they had sold every bond in their inventory by 11 a.m.

Overall, municipal bond rates are probably 15 basis points lower today than on Friday, while Treasury rates are about 15 basis points higher. Strong retail demand is critical for improvement in the muni market. First, it means that long-term buyers are soaking up the massive supply hitting the market. Second, it means that long-term buyers have not lost confidence in municipals amidst the bond insurer problems.

So what happened to the arb fund selling? I've heard that the arb funds had to meet margin calls on Friday, but seem to now have adequate margin to move forward. That being said, we are still seeing arb funds selling, but it's coming in the form of smaller lists of offerings, as opposed to bid lists. The difference is the degree of desperation. A bid list means you need cash now, an offering list means you will sell bonds, but only if you get your price.

The bottom line is that the muni market looks a lot stronger than I initially expected.