April 20, 2015
This week, we examine data from the U.S. Treasury on State and Local Government Series Securities and draw conclusions regarding the pre-refunded bond sector and the muni market in general.
We recently discovered an interesting data set. The U.S. Treasury publishes data regarding amount of State and Local Government Series Securities (SLGS) outstanding.
Since the yield-burning crackdown in the 1990’s, SLGS have been one of the primary instruments used by municipal issuers to fund the escrow in advance refunding transactions. A look at the historical SLGS data has the potential to yield insights on developments in the pre-refunded bond sector and the composition of the municipal market.
After remaining relatively unchanged from the late 90’s to the early 00’s, the amount of SLGS outstanding almost doubled between ’05 to ’07. The decline in SLGS outstanding since that ’07 peak has been even more dramatic. Since peaking at $297b in November ’07, the amount of SLGS outstanding has shrunk to $119b.
While securities other than SLGS are used in refunding escrows, we think the SLGS data can serve as a good proxy for the pre-refunded bond sector. Using SLGS as a proxy for pre-refunded bonds, we conclude that the amount of pre-refunded bonds outstanding is shrinking.
We believe this reflects the relative unattractiveness of advance refundings since the financial crisis driven by high muni to Treasury ratios and the extra credit spread required on munis in the absence of monoline insurance, which have offset the low levels of interest rates.
One method of measuring of the attractiveness of advance refundings is to compare the interest rate on a long muni bond to a short maturity Treasury. This relationship is important, because it compares the yield at which the issuer is borrowing (long muni) with yield at which the proceeds at being invested in the escrow (short Treasury). This relationship is sometimes referred to as “negative arb.”
The chart below displays the yield on the Bond Buyer 25 Bond Revenue Index to the yield on the 5 year US Treasury.
While the negative arb has been improving, it is still worse than at any pre-crisis point dating back to ’95.
In addition to getting smaller, we believe the pre-refunded market is getting shorter. Using the Treasury data, we can make a rough estimate of the average maturity of SLGS outstanding.
After a long period of relative stability, the universe of outstanding SLGS has been shortening steadily since August ’11 (6 yearsà 3.4 years).
Because of the role the municipal bond market plays in financing infrastructure, changes (reductions) in the amount of municipal bonds outstanding are frequently cited by advocates in favor of increased infrastructure investment.
As we have discussed in a previous Commentary, State primary debt has actually been increasing.
The most frequently cited source for the size of the municipal market is the Federal Reserve. According to the Federal Reserve statistics, the municipal market has shrunk 2.7% since ’10.
If we remove SLGS (pre-refunded proxy) from the Fed data, instead of shrinking by 2.7%, the market actually shrunk by only .7%. Given the historic imprecision of the Fed data, this is likely within the margin of error.
New Jersey Downgrades and Spread Widening Continue
Moody’s lowered its rating on the State of New Jersey to A2 last week and maintaining a Negative Outlook. New Jersey has experienced several downgrades and significant spread widening since we addressed its challenges in our Commentary last fall.
Have a great week,
Michael Craft, CFA
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