Luminous Capital Partner Alan Zafran has been charting bond prices and says in a note to investors that understanding what’s happening in the bond market is key to knowing when falling prices represent a buying opportunity.
Check out the table below. These are dramatic moves downward in price.
Why is this happening?
1. U.S. Treasuries have sold off sharply following the announcement of QE2, and municipal bond yields trigger off of Treasury yields.
2. As a trader/investor, you canâ€™t directly short municipal bonds; the market is one-directional. Names either get bought or sold. So the municipal bond market got overbought and was ahead of itself. This was exacerbated by the fact that municipal bond funds that are performance-driven could not afford to hold cash at 0.00% yields and therefore were fully invested into the QE2 announcement.
3. Municipal bond ETFs are getting sold, and that is causing the underlying bonds of the ETFs to be sold (further causing sellers to appear in the municipal bond marketplace). Municipal ETFs are a bad idea, and is this all we need to see the evidence of this fact. Municipal bonds aren’t liquid enough to have an ETF tied to them.
4. There are lots of leveraged holders of municipal bonds (e.g. the Oppenheimer Rochester National Municipal Bond Fundâ€”ORNAXâ€”is 20% leveraged).
5. There has been talk of a possibility of the elimination of the BAB (Build America Bond) subsidy from the federal government at year-end, instigating a very large issuance of long-term municipal bonds.
6. Consequently there have been very high levels of supply of municipal bond issuance this week due to the municipalities’ budget needs and the potential elimination of the BABs subsidy. (See chart below).
7. Investor fear has therefore led to bids disappearing in a less liquid municipal bond market (broker dealer desks get hit hard initially and subsequently have less willingness to support the market and buy more bonds as sellers show up).
8. Pouring salt on the wound, tobacco bonds were downgraded to junk (BB- from BBB) by S&P and have widened by 1.00% (a huge move) in the last week. In price terms, this means the Ohio Buckeye Tobacco bonds maturing in 2047 fell from $103 to $93 (10%) in a week!
When will this be a buying opportunity?
Likely soon. Intermediate-term positives include:
1. The U.S Treasury sell-off may hit some technical support levels.
2. The BAB subsidy may be negotiated and included in a tax cut compromise.
3. Municipal bond supply tends to be markedly reduced once Thanksgiving arrives. Most of the supply will be gone in a week.
4. Eventually investor fears will subside and investors will recalibrate to a new, higher-yielding environment. For instance, the North Texas Tollway executed a new bond issuance today at a yield of 6.25% (vs. the 5.25% initial price talk).