Total issuance of new municipal bonds may set a record in 2010, but the real story for investors is the composition of new bond issuance. Wall Street forecasts range from $415 billion to $450 billion in new municipal bond issuance for 2010, with most forecasts clustered towards the upper end of that range.
New municipal bond issuance in 2010 therefore stands a chance to break the 2007 new issue record of $435 billion. Supply is one of the most important drivers of municipal bond performance and manageable supply helped produce good performance in 2009.
What’s the Issue?
Issuance of new bonds is important since it can have a notable impact on the supply-demand dynamics that influence bond pricing and yields. New issuance is more important in the bond market, relative to equity markets, since bonds have maturity dates and new issuance is a more constant factor in the market. Furthermore, bonds (with few exceptions) are not listed on exchanges and trading is over-the-counter, making it more sensitive to supply-demand variations.
However, what matters for most municipal bond investors is the dollar amount of traditional tax exempt issuance. Prior to 2009, taxable municipal bond issuance averaged 5% of total municipal bond issuance. In 2009, taxable municipal bond issuance amounted to 20% of all municipal bond issuance thanks to the Build America Bond (BAB) program. BAB issuance may exceed $100 billion in 2010 and may reach as much as $140 billion according to some estimates. Subtracting $100 to $140 billion from the $450 billion high estimate for 2010 overall municipal issuance leaves a $310 billion to $350 billion range for traditional tax exempt issuance. This level is roughly in line with the $325 billion in 2009 tax-exempt issuance. If tax-exempt issuance reaches $350 billion in 2010 it would still be the lowest level since 2004.
Therefore the traditional tax-exempt bond market is expected to see little, if any, growth in 2010 at a time when demand is expected to remain high. A number of states have already increased tax rates for 2010 with more likely to follow. At the national level, the top tax rate is set to revert back to 39.6% from the current 35% at the end of 2010. In addition, demographics reflect a growing investor base for tax-exempt income.
Build American Bond Program
The BAB program is widely expected to be extended beyond its current year-end 2010 expiration but additional expansion of the BAB program could result in even fewer tax-exempt bonds. Lawmakers are currently deciding whether to allow BAB new issuance be used to refinance existing tax-exempt bonds. Should such a provision be added, BAB issuance could increase further and reduce the supply of traditional tax-free bonds further.
BAB bond issuance has been well received in the market. BABs offer slightly higher yields than comparably rated corporate bonds. Although the yield differential is not as wide as when BABs initially launched in April 2009, the differential still is attractive to taxable bond investors, foreign buyers in particular, looking to diversify existing corporate bond holdings.
BABs issuance has a greater impact on the longer-term portion of the municipal bond market. BABs are issued for infrastructure and other longer term projects which require longer maturity bonds. Additionally, since long-term municipal bonds, rather than short-term bonds, are more cheaply valued to Treasuries, longer-term BAB issuance is more economically advantageous for states and municipalities. Roughly 95% of BABs have maturities of 10-years or greater. As a result, the supply impact, or lack of it, will more greatly impact longer-term municipal bonds. This is another reason why we continue to favor intermediate and longer-term maturity municipal bonds. As mentioned in our 2010 Outlook, the BAB issuance dynamic is a key reason why we believe longer-term municipals should prove resilient to the prospect of rising interest rates.
New issuance is of particular importance in the municipal bond market since it is more sensitive to changes to supply-demand dynamics compared to the taxable market. Individual investors, either directly via individual bonds or indirectly via mutual funds, comprise the vast majority of the market. If new municipal issuance leads to a sudden increase in supply at a time when individual investor demand is relatively weak, lower bond prices and higher yields may follow. Conversely, when demand is firm and new issuance is relatively light or non-existent, bond prices may rise as a result.
What About Taxable Bonds?
The taxable market, on the other hand, is dominated by institutional investors who are mandated to be fully invested and stay close to targeted investment benchmarks. Institutional investors tend to be more broadly diversified and are constantly reinvesting maturing bonds back into new bonds. This creates more steady demand regardless of conditions and makes the taxable market less sensitive to individual investors whose buying interest is much influenced by the level of interest rates rather than a particular benchmark or allocation.
This dynamic is a key reason why the municipal market has historically proven to be less sensitive to rising interest rates. Conversely, the municipal market has often lagged the movement in Treasury yields when interest rates decline.
As the New Year begins, municipal bond investors will see headlines for a potential record year of municipal bond issuance. However, the issuance of traditional tax-exempt bonds will be near the lowest levels of the past several years. Reduced tax-free bond supply as a result of BAB issuance and potential expansion, coupled with rising tax rates and a growing investor base, indicate the favorable supply-demand balance that benefited municipal bonds in 2009 will continue in 2010. We continue to favor intermediate and longer-term municipal bonds where valuations and supply issues provide a more favorable backdrop.
- This was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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