Diary of a Financier

Muni buying opportunity with short term top spotted in the 10-year

In Capital Markets on Thu 5 Sep 2013 at 17:53

Just a quick update on the 10-year Treasury yield ($TNX) here. One month has passed since my last update on Treasury yields, when I focused on the secular end of disinflation. What follows is a bit more short/intermediate term and tactical…

TNX ended today at 2.979 after an intraday high of 2.984, so it’s closing-in on 3%. This week, it broke-out above the soft 2.86 resistance I last drew.

I think we’re reaching a short term high. Not only are weekly and monthly fractals extremely overbought, but TNX’s daily chart shows 3x bear divergence. Next resistance is another weak one @ 3.025, TNX daily/weekly/monthlybut I’d expect that to mark a short term top for TNX, with the potential for the 10y to pullback to its 50DMA (now @ 2.663).

Further out, it looks like resistance @ 3.22 is a more intermediate-term target and perhaps a resting-ground for this rally. Thereafter, 3.75 and 4.00 are robust levels that pose longer-term snags, as best exhibited by the weekly chart.

This assessment gives me pause, because of its negative implications for cross-asset performance. However, if rates decline as envisioned, the backup could be mutually exclusive of risk-off equity selling. After all, the yield curve has undergone bear steepening, with the short end falling amidst rising long term rates: 3mo T-Bill yields ($IRX) have actually declined from 65bps in April to 16bps today. That confirms the dynamic we’ve seen in our business, wherein clients have swapped-out of duration to shorten up interest rate risk. That suggests these curve permutations are intra-asset dynamics, representative of investors shuffling the composition of their bond holdings.

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Affirming that notion of a short term pullback in yields, I’m seeing a lot of value in the muni market lately—maybe the best relative value I’ve seen in 4-5 years. Massachusetts tax-free paper is trading with 7-8% taxable equivalent yields (e.g. split-rated AA+/AAA 5s of ’28 with ‘23 call @ 4.1% YTC/4.6% YTM). I see the same in New York, Connecticut, Pennsylvania, and of course Texas, which doesn’t have state income taxes.

Our traders liken this more to the couple months of inversion in 2008-09’s muni market than the couple days of dislocation caused by Meredith Whitney in 2010. Munis historically trade at a 80-90% discount to Treasuries due to their tax-free status, but in 2008-09, Muni/Treasury ratio (10y yields)that ratio spiked to 220% due to heavy selling in what’s always been a low-liquidity market (at the CUSIP level). The Muni/Tsy ratio has remained elevated since that crisis, but spreads have really widened in the last two months—largely attributable to the fear instilled in buyers by Detroit’s default and Puerto Rico’s deterioration (i.e. credit risk).

Listen, risk free rates are going higher, no doubt, but the muni market shows good value from the belly of the curve to the long-end. Some short term (1y) AAA munis are trading at negative yields, as are Agencies. Investors have fled longer maturities for fear of duration risk. They’ve rolled down the curve, and now it looks overdone. We had pensions and sovereign wealth funds selling munis by the boatload this summer, having originally bought them for the incremental yield over Treasuries and Agencies.

Henceforth, retail in particular might press the gas again—selling the long end/buying short end—when news of a Fed QE taper hits the front page. Regardless, value’s already manifest in the muni market. You can’t forget that interest rates theoretically discount future expectations of growth and inflation. Considering that, plus the fact that the Muni/Tsy ratio is ~115% with spreads widening due to those aforementioned fears of credit risk, the muni market has provided a nice entry point here.

For a strategic, hold-to-maturity bond buyer, 7% TEY for 10 years (to call) or 8% for 15 years (to maturity) ain’t that bad sounding, especially when you consider most people have 3% 30y mortgage debt that’s tax deductible.MLN fundamentals For the bolder, more tactical trader, the Long Term Municipal Bond ETF ($MLN) is the vehicle of choice.

If I were to participate in this theme–and I have clients to whom I’ve recommended it–I’m more likely to opt for singlenames myself. Although bid/offer spreads on individual bonds are wide enough to drive a truck through right now, my time horizon is longer term, for which the constant maturity feature of bond ETFs is the biggest risk, given the potential for permanent principal loss.

–Romeo

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  1. […] me expect curve steepening with sweet spot <5 years–don't forget that <2y yields actually fell during the summer's rate rally.  See also: "Optimal Control" (below)] #Bullish $SHY […]

  2. […] curve steepening with sweet spot <5 years–don’t forget that <2y yields actually fell during the summer’s rate […]

  3. […] 10y behaved in splendid accordance with my last assessment, giving us a nice entry point for some tactical scalps in the muni space when TNX slipped >3% […]

  4. […] doing this for a couple reasons.  First, munis still trade near historically wide spreads over Treasuries on a taxable equivalent yield (TEY) basis, so […]

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