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Credit Worries Not Driving Muni Market

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. In recent weeks there's been a rather sharp sell-off in municipal bonds. Here today to give his take from the trading floor is Jed McCarthy. He's the Managing Member of 16th Amendment Advisors.

Jed thanks for joining me today.

Jed McCarthy: Hi, Jeremy.

Glaser: First off, can you give a sense of how big of magnitude of the sell-off this has been?

McCarthy: There's been quite a big sell-off in municipals in the last couple of weeks. Although in the last few trading days, things have firmed up from the lows. You really have to go back to the dark days of the last quarter of 2008 to take a time when munis have been in such disarray. To try to quantify what the sell-off has been, about two weeks ago AAA long-term munis were yielding about 4% and at the very high of the few days ago they got up to about 4.60 yield.

Glaser: So have we seen any firming in the market, since those peaks?

McCarthy: We have and that started really at the end of the week last week, where some of the forced selling that have been going on from some of the mutual funds seems to have abated. That coincided, with most of the calendar from a very heavy week having been mainly priced and because of that, the market firmed up pretty nicely, in the tune of about 20 basis points or so.

Glaser: So in last few weeks, obviously, we've been hearing about sovereign credit risks and people worried about credit. But what's your view as to what precipitated the sell-off, was it really a credit event or is there something else going on here?

McCarthy: I really don't think it was a credit event. Munis have suffered from what I'll call negative headlines, really for the last couple years. But recently, there really have not been any kind of big headline credit events in munis.

In fact some of the ratings services, Moody's and S&P have recently come out with a validation of municipals being very firm and stable credits and have expressed a view that, lot of the more sensational headlines in the news have been somewhat overblown. So, I don't think it was a credit event. It was really based on a large supply of munis coming to the market in a short period of time.

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Glaser: So there seems to be this big flood of bonds on to the market, do you think this is related to the potential ending of the Build America Bond program?

McCarthy: Yeah, I think that's a very big part of it. Our market right now is somewhat bifurcated, where we have supply, which is from the BAB program, which is taxable, along with a traditional tax exempt supply. Recently, we have been seeing a very large calendar in both. Along with the couple of very large issues. Last week, we saw a lot of debt being priced by the State of California as they came with both the taxable issue and a tax exempt issue, as an example.

Glaser: When we think about potential outcomes, no one knows that the Build America Bond program will be renewed or not. But if it isn't, what do you think some of the impact that is going to have on both new issuances and on pricing in the muni market?

McCarthy: Well part of reason why the calendar has been so heavy is because the BAB program is due to expire at the end of this year and there's been talk for the last nine months or so of the possibility of extending that. Now the other component of that is that even if it does get extended, it might get extended at a much lower subsidy rate. Right now 35% of the coupon of the BAB deal is rebated back to the issuer by the Federal Government by the IRS.

Even the scenarios that predict an extension of the BAB program, contemplate a lower subsidy rate. So, if you're an issuer and you're deciding when to come to market, it's pretty obvious actually that you want to come to market before the end of this year to take advantage of the program and the higher subsidy rate.

Glaser: So we're certainly seeing a lot of front-loading of that financing. How do you think the impact of the last couple of weeks of weaker pricing, do you think that's going to have a lot of issuer's kind of holding back?

McCarthy: I don't see that yet. I see maybe a couple of issues that have been pulled from the market, where they went out originally, with a tighter price talk and realized that there is no market at those levels and then backpedaled and got to the point where they just pulled issues. But up until now, that's really been an exception rather than the rule.

Glaser: So, maybe not something that people should expect a huge contraction in supply. But kind of looking in the medium term, would you see there wouldn't be a lot of issuance available for investors to see in early 2011?

McCarthy: Yes. I think that in a matter what, we're going to see a lot of supply through the end of the year, which looking at the calendar right now, that's only really a matter of about three more weeks before you start getting into the holidays. So, I think no matter what, you're going to have that, and I also think the first quarter of next year, especially in January, you're going to have very light supply.

Glaser: So these dislocations, we could still see some more in the marketplace, but they don't really reflect an underlying change in credit sentiment. It probably is more to do with just those basic economic laws?

McCarthy: Yes and also sometimes supply can force redemptions. A lot of times municipal investors will have to create room in their portfolios by selling bonds. Sometimes there is some poor selling's that can lead to deleveraging, kind of the story that we had back in 2008, and we did see a little bit of that, but to a much lesser degree than we saw in 2008.

So, I think that increased the momentum of the sell-off over the last couple of weeks. But going forward, I think we're actually starting in January pretty bullish, both on the taxable side and the tax exempt side, because, after you get through the supply, things should be a lot better.

Glaser: Alright, great. Jed, thank you so much for your insight today.

McCarthy: Okay. Thank you, Jeremy.

Glaser: For Morningstar.com, I am Jeremy Glaser.