Government & municipal bonds | Liquidity | Lynn Strongin Dodds
“Many of the muni dealers
can be boutique shops that
are smaller specialists and
for whom automation of
settlement instructions and
trade matching has not always
been a priority.”
Kevin Arthur, Omgeo
Municipal bonds:
The dry states
Despite a positive primary market, muni traders face a volatile and potentially
illiquid secondary market this year. Lynn Strongin Dodds reports.
New rules could drain liquidity from the municipal
bond (munis) market while the expected rate hike
could dampen issuer activity and cause investors
to look for richer pastures elsewhere.
Thomas Doe, president and founder of
Municipal Market Analytics (MMA), says, “The
worst case is that the cost of business becomes
too high and capital dries up. One of our biggest
concerns is that regulation, although well intended,
will reallocate capital away from the municipal
market and this will have a significant impact on
infrastructure where there is a great funding need.
The best case is that there will be enough new
issuance that will cover new projects.”
Weaker than expected US growth in the first
quarter coupled with disappointing employment
figures is likely to delay any movement in interest
rates. However, when they do start their upward
climb, the theory is that investors will switch their
attention to short term bonds from their long term
counterparts which lock in yields for extended
periods, making their prices more sensitive to rate
changes.
The impact of new market rules, proposed
by the Municipal Securities Rulemaking Board
(MSRB), divides opinion. They will push for greater
transparency over trade reporting and a stricter
fiduciary requirement for advisors, which would put
the interests of state and local government issuers
ahead of advisors’ own concerns. The rule, a key
plank in the MSRB efforts to regulate the group
under Dodd Frank, is subject to approval from the
24The Desk | Summer 2015
Government & municipal bonds | Liquidity | Lynn Strongin Dodds
“There is one view that liquidity will
lessen because traders and investment
banks will have to tighten standards
and jump through more hoops to trade
the bonds. However, some people think
that the greater transparency could
lead to increased volume.”
Jon Barasch, Interactive Data
Securities and Exchange Commission and if passed,
it will affect around 740 firms and 3,800 individuals.
Jon Barasch, director at Interactive Data says,
“There is one view that liquidity will lessen because
traders and investment banks will have to tighten
standards and jump through more hoops to trade
the bonds. Investment managers will not want their
ability to transact limited, because if they need to
redeem they want to do it quickly. However, some
people think that the greater transparency could
lead to increased volume.”
All agree though that the trade reporting
proposals could dent the operational bottom line.
They will require dealers to report new information
through the Real-Time Transaction Reporting
System, such as whether a trade occurred on
an alternative trading system or involved a nontransaction based fee. They would also include an
indicator for non-transaction based fees.
In practice this would mean reconfiguring
systems and increasing automation, according to
Kevin Arthur, director of fixed income markets at
Omgeo. “We are working closely with SIFMA and
the MSRB. Operationally firms want to be able
to achieve as much efficiency as possible from
automating their post trade processes. Many of
the muni dealers can be boutique shops that are
smaller specialists and for whom automation of
settlement instructions and trade matching has not
The Desk | Summer 2015
always been a priority. However, since munis settle
at the DTCC, all the self-clearing and correspondent
brokers have automated to TradeSuite ID for
electronic confirmation processing. While the
confirmation process will not prevent defaults and
credit events like the Puerto Rican example, they do
provide processing certainty, reduce operational risk
and an electronic path to settlement.”
Rough weather
Puerto Rico’s financial woes as well as Detroit’s
bankruptcy in 2013 have left their mark. The car
capital of the US has already set the wheels in
motion for a restructuring plan while, Puerto Rico,
a US commonwealth, has struggled to meet
its debt obligations, which exceed the US$70
billion mark. Unlike some US municipalities, its
constitution prevents the government and public
companies from seeking protection from creditors
in bankruptcy courts. The government passed a
so-called Recovery Act, which would have allowed
some of its largest utilities, such as the Puerto Rico
Power Authority, to negotiate with bondholders
to reduce large debt loads. However, a court
overturned the law and the government is currently
appealing against the ruling.
“Puerto Rico did hurt the market in 2013 but
ownership of the island’s credits is more in the hands
of investors who know the risk at this point – hedge
25
Government & municipal bonds | Liquidity | Lynn Strongin Dodds
“One of our biggest concerns is that
regulation, although well intended,
will reallocate capital away from the
municipal market and this will have
a significant impact on infrastructure
where there is a great funding need.”
Thomas Doe, Municipal Market Analytics
funds, high net worth individuals and high yield
funds,” says Doe. “Nonetheless should PR have
greater distress, the associated media headlines
could still prompt mutual fund outflows which would
hurt the broader market. In 2015, there is less capital
than in 2013 to provide an orderly secondary market
should fund holders redeem. The result is volatility
in bond evaluations that has a history of driving
individual investors out of the tax-exempt sector and
borrowing costs for issuers higher.”
Barasch, agrees that “it did scare people and
they are wondering which city could be next but I
do not think the impact of Puerto Rico’s financial
problems was that great because it is an isolated
segment of the market and only accounts for US$70
billion out of a US$3.7 trillion market. For example,
this year we are seeing record issuance, largely
driven by issuers refunding debt at lower interest
rates. Everyone expects interest rates to rise and this
is pushing deals to get done as fast as possible.”
Primary: strong. Secondary: choppy
Research from Oppenheimer Funds shows that
long-term muni bond issuance reached new
issuance heights at US$102.6 billion in the first
three months of 2015, up significantly from the
US$64.3 billion in the same period last year and
slightly down from the US$103.3 billion in the last
quarter of 2014. The 12-month rolling average hit
a 22-month high but is still 14% lower than 2010
which was a record year.
Demand was just as strong with municipal
bond mutual and exchange-traded funds attracting
net inflows of US$32 billion in 2014 while the first
two months of 2015 alone, saw an additional
US$8.6 billion. The main participants are individual
investors who are attracted to the prospect of
tax-free income, particularly given higher federal
income-tax rates. Income from muni bonds is free
from federal taxes and can also be exempt from
state and local taxes in some cases.
Performance has also been a draw with the
Barclays Municipal Bond Index, an index of a
broad range of investment-grade municipal bonds
that measures the returns of the general muni
bond market, rising 1.01% in the quarter ended
March 31, 2015. This was only slightly ahead of the
S&P 500’s total return of 0.95% but higher than the
Dow Jones Industrial Average’s sluggish showing
of just 0.33% for the quarter.
Looking ahead, though, analysts are not
optimistic that the final tally this year will match
2014’s stellar returns of 8.71% which were under
the 15.3% for the S&P 500, but ahead of the 6.97%
for highly rated corporate debt and 4.6% for US
Treasury debt, according to figures from Bloomberg.
As Peter Hayes, head of the municipal
bonds group at BlackRock observed in a recent
note, “Everything that didn’t work in 2013 worked
in 2014: Long-duration and higher-yielding credits
led the market as investors stretched for yield. Rates
fell and prices rose, lending additional support. And
2013 outflows reverted to solid inflows. All told, the
stars aligned in spectacular fashion.”
However, he added, “continued market
volatility is likely amid uneven economic data and
a Fed readying to raise rates. We are monitoring
liquidity in the market given that a highly uncertain
macro backdrop makes it difficult for investors to
demonstrate convictions in their views.” n
26The Desk | Summer 2015