1861 Capital Management Investor Insight
Long-term new issue supply in December was $26.9 billion, down approximately 36% from December of 2010. For the year, new issue volume reached a 10-year low of about $294.9 billion, down about 32% from 2010. Tax-exempt or AMT issuance declined 6.6% over the year, while taxable issuance declined by 78.8%. Insured bond issuance declined to 5% of issuance for the year.
The partisanship in Congress continues unabated with the dispute over the extension of the payroll tax cut continuing to late December and President Obama using a recess appointment to appoint the head of the Consumer Financial Protection Bureau which is likely to be challenged by Republicans. Municipal market participants may take comfort in this partisanship during an election year, as very little in the way of tax reform is likely to be enacted in 2012. Despite this, the market may react to the talk of major tax reform (such as flat tax proposals) even if serious legislative tax reform efforts wait for 2013. There is always the risk of minor "revenue enhancement" restrictions on the municipal market which could happen at any time.
The municipal market is also an old-style, over-the-counter market. Information is not readily available, nor is access to bonds, without strong “street contacts”. Estimates suggest there are over 60,000 municipal issuers and 1.5 million individual securities. Bonds can only be sold if they are held. Good relationships with the street and other municipal buyers are essential to being shown attractive blocks or allocations on new issues and to get information on who is doing what (following supply and demand factors). Quality sales coverage is essential, and it takes market experience and relationships to filter all the market information available and focus on what is most important. We strongly believe that municipal professionals are needed to successfully trade municipal securities and manage a complex portfolio.
1861 Capital Understands What Needs To Be Done in The Bond Market
An understanding of the complexities of muni bond math is a start, but extensive experience in the muni market is required to manage the duration, convexity (gamma), volatility (vega), and yield curve exposure of a portfolio. The options embedded in municipals are quite complex so standard bond math analytics generally would not be sufficient to capture the risks. Most munis are callable and therefore contain embedded short calls. Some munis are advance-refundable which is equivalent to another embedded option. A more complex embedded option effectively results from the market discount rule, which all munis are subject to.1861 Capital Archive
Over September, 30-year Treasury bond rates fell 69 basis points to 2.91% and 30-year MMD rates fell 34 basis points to 3.55%. Long-term new issue supply was $27.4 billion, down 23% from September of 2010. Low interest rates are being reflected in the issuance composition, as refunding and combined refunding/new money issuance was up 11% from last September, while new money issuance was down by 49%.
Tax reform continues to be discussed in Washington, both in proposed legislation and on the campaign trail. In early September, President Obama introduced his jobs bill which would cap the value of the muni bond tax exemption at 28%. In September, he also proposed in a speech what is being called the "Buffet Rule" and submitted legislation titled "the Debt Reduction Act of 2011" to the deficit committee, both of which could potentially affect the municipal market if enacted. The Buffet Rule calls for a new minimum tax rate for individuals earning more than $1 million per year to ensure that they pay at least the same percentage of their earnings as middle-income taxpayers. Tax preferred income such as capital gains, dividends, tax-exempt muni bond interest, other tax-preferred investments, and limitations on the amount of income subject to security taxes often causes this lower overall tax rate. Therefore, it is likely that munis will be a part of any proposed tax legislation, although the enactment of any major tax legislation before the election in 2012 is unlikely.
The Debt Reduction Act of 2011 would target declines of 0.2% per year in the debt to GDP ratio with automatic cuts to spending and tax preference items (such as the tax-exemption for muni bond interest) if this reduction is not achieved. The determination would be made annually, with the taxation on muni bond interest ranging from non-taxed to fully taxed as ordinary income. With no certainty, municipal yields could rise sharply as individuals price in the risk of reduced or no benefit. With that, state and local governments would likely suffer from higher interest costs. On the flip side, the federal government may not receive any additional income from this as the debt ratios may well decline and cuts to tax preference items may not be required.
The deficit committee has been in a fact finding period but will soon begin considering proposals to meet their deficit reduction mandate. Their recommendations should be watched closely, as their recommendations have the best chance to be enacted in the short term. On the campaign trail, several Republican candidates have presented proposals. Romney proposed that there would be no taxation on interest, dividends, or capital gains for people earning less than $200K per year. This would eliminate the preference for muni buyers in the 28% tax bracket, which could result in muni yields rising sharply to a point where higher tax-bracket taxpayers alone could clear the market. Cain and others have proposed flat taxes and or national sales taxes, most of which would have all interest income not taxed. Munis would lose their preference without being able to grandfather existing holdings. Muni yields would likely rise very sharply under these types of plans. We want to point out that major tax reform is very difficult and takes a very long time. The last time it was achieved was in 1986, and that took close to 3 years from start to finish. We would not take any action now based on major tax reform proposals, though smaller changes associated with deficit reduction or the jobs bill are certainly possible. In our opinion, in this environment, it is critical to maintain high liquidity, both to be able to shift holdings if necessary and as liquid bonds will likely outperform illiquid ones if legislation creates sudden shifts in demand.
1861 Capital Monthly Supply Note – November 2010
Over November, 20-year LIBOR rates rose by 20 basis points and 20-time
MMD rates rose 46 basis points to 3.94%. Long-term new issue supply was $45.1 billion, an increase of about 18% from last November. Taxable vehicles is about one-third of issuance so far this year, at $131 billion through November.
Although not yet final, it does not appear that an extension of Build America Bonds will be in the tax plan agreed to by President Obama and the Republicans.
1861 Capital Monthly Supply Note – October 2010
Over October, 20-time LIBOR rates rose by 25 basis points and 20-year MMD rates rose 19 basis points to 3.48%. Long-term new issue supply was $45.6 billion, a decline of about 1.6% from last October. time-to-date long-term issuances is about 3% higher than the same period last year. Taxable issuance is about 33% of vehicles so far this time, at $112.4 billion through October.
The monoline insurance companies were in the news a lot in the last few weeks, with Assured Guaranty losing its AAA rating and Ambac Financial Group Inc.’s filing for bankruptcy. With S&P’s downgrade of Assured Guaranty, there is no longer any AAA rated monoline insurance wrap for municipal bonds. This downgrade was based on a change in view by S&P of the demand for bond insurance and the resulting strength of this business.
The results of the mid-term elections have somewhat diminished the chances of an extension of the Build America Bond (BAB) program. There is still some support in the current Congress for an extension, but it is uncertain whether legislation will be able to be passed during the lame-duck session. A failure to extend BABs would result in higher tax-exempt issuance next year.
1861 Capital Monthly Supply Note – September 2010
Over September, 20-time LIBOR rates rose by 18 basis points and 20-year MMD rates rose 1 basis point to 3.29%. Long-term new issue supply was $31.0 billion, up about 3.6% from last September. Of this issuances, about 32% was in taxable bonds. Taxable Build America Bonds are about 1/3rd of long-term issuance so far this time.
Congress recessed without first passing an extension of the BAB program. They will likely consider the extension upon their return in mid-November, but issuers must now decide whether to take the chance on an extension or bring a deal by the end of the year to lock in the ability to issue taxable bonds with a 35% subsidy rate. Many will choose to bring deals, such as the NJ Turnpike Authority which said that it anticipates bringing $2 billion in BABs to market in mid-November. It is possible that a surge of BAB vehicles towards the end of the time could cause spreads to widen.