The Bond Buyer spoke with Terry O’Grady, FMSbonds’ chief bond trader, about the “anomalies” in the bond market.
The industry publication says forced selling “has distorted some segments of the market into bizarre contortions.”
The article by Dan Seymour continues:
Three peculiarities in particular – prerefunded bonds yielding higher rates than the Treasuries backing them, corporate-backed munis trading at higher rates than the bonds of the corporations backing them, and higher relative yields on insured bonds implying that insurance detracts from the likelihood of repayment – are anomalies with no plausible explanation other than more people selling than buying.
“Logic is out the window when market forces take over and forced selling comes in,” said Terry O’Grady, senior vice president of municipal trading at FMSbonds.com, a muni boutique based in Florida. These idiosyncrasies go beyond stretching historical relationships or foiling ratios previously taken for granted.
The deleveraging of the entire financial system has turned many investors into unwilling sellers, according to O’Grady.
While more retail investors have been beckoned into the market, there are not enough of them to meet the supply from the sellers, he said.
“The smartest guys in the room are the guys that are behaving like the dumbest people in the room,” O’Grady said. “None of the institutions want to be selling the bonds they’re selling at these levels. It’s got to pain these money managers to be liquidating these bonds into these markets.”
Meanwhile, O’Grady said this is a “historic buying opportunity in municipals.”
Treasuries on the cheap
With Treasury bonds on a stunning run – the three-month bill last week carried a negative interest rate – many investors probably wish they had bought Treasuries when they were cheaper. Because of a quirk in the muni market, they still can. The answer: prerefunded munis. A prerefunded muni is a state or local government bond slated to be repurchased from the bondholder at a future date.
In the meantime, the issuer buys Treasuries maturing when the bonds are scheduled to be repurchased. The Treasuries are placed in the refunding escrow and support the coupon payments on the munis, effectively allowing the government to refinance its debt.
The upshot is the bond’s coupons are secured by the Treasury’s credit, funneled through a municipality’s tax-exempt interest payments.
The market has historically attached rich value to tax-exempt interest payments supported by the most creditworthy borrower in the world.
Since the turn of the century, five-year prerefunded munis have usually yielded less than 90% of five-year Treasuries, according to Municipal Market Data. They have often traded at less than 80%.
In 2007, yields on five-year prerefunded munis matched the yields on their counterpart Treasuries for the first time. This summer, the yields spiked. They now yield more than 170% of five-year Treasuries.
By buying a prerefunded muni, an investor can collect tax-free interest payments backed by the Treasury at a higher rate than the Treasury’s own taxable rates.
The counterpoint defies explanation….
Excerpted from The Bond Buyer, December 15, 2008.