What a difference a week makes. Last week's article pointed out how overpriced the municipal market was, and that in the shorter maturities -- 7 years and less -- taxable bonds offered greater after-tax returns than the tax-exempt yields available on early municipal maturities. Little did we realize that the roof was about to fall in on the bond market.
Within a week, the issue many investors use to measure the price movement in the long municipal sector, the New Jersey Twp. 7.20 percent due Jan. 1, 2018, had plummetted 5 1/4 points ($52.50 per $1,000 bond), while its yield rose 55 basis points. Concurrently, the 30-year T-bond fell only 2 1/4 points ($22.50 per bond), while its yield increased 22 basis points.
Over the same time frame, the yield on the five-year AAA general obligation bond rose from 5 percent to 6.30 percent; the 10-year, from 6.45 percent to 6.95 percent; the 20-year from 7.45 percent to 8.10 percent, while the yield on the 30-year AAA general obligation jumped from 7.70 percent to 8.20 percent. These are drastic changes when you consider that the new issue volume was slight and that it occurred in only seven days.
With the tax-free yields rising so rapidly, the ratios of tax-exempt yields to taxable Treasury yields moved higher, so that the tax exempts have become more attractive than they were just seven days ago. A week ago, the ratio of the five-year taxable T-note to the five-year tax-exempt AAA general obligation bond was 0.64 (5.60 percent to 8.75 percent). As of Sept. 10, the ratio had increased to 0.69 percent (6.25 percent to 9.01 percent). By the same token, the 10-year relationship changed from 0.70 (6.45 percent to 9.24 percent) to 0.73 (6.90 percent to 9.46 percent).
One of the main reasons for the rapid change in the muni market was the dealers' approach to selling pressures that developed during the past several days. Last spring the dealers bought millions of dollars of tax-exempt bonds from open-end mutual funds (which were faced with heavy redemptions), and suffered severe losses as bond prices declined.
This time around, the dealers kept lowering their bids as selling emerged. Many of the sellers, faced with "poor" bids, simply did not complete their sale programs as the bids kept falling.
The question is, what happens now? Another increase in the discount rate is expected, so it is doubtful that bond rates will be moving significantly lower any time soon. However, the volume of new muni issues has slowed, and the new higher-yield levels will preclude any further "refundings" of outstanding issues, which so far this year have accounted for 47 percent of the new issue volume. That new issue volume has averaged $8.5 billion a month so far in 1987. You have to go back to 1984 to find such a light volume.
So it would appear that if we stall at these higher yield levels, munis will be more attractive than treasuries. The shortage of new issues should help munis to outperform treasuries as the year rolls to a close.
James E. Lebherz has more than 28 years' experience in fixed-income investments.