AAA States Beating Market for First Time Since 2008: Muni Credit

The highest-rated U.S. states are set to beat the rest of the $3.7 trillion municipal market for the first time since 2008 as the worst bond rout in more than two years draws investors to safer debt.

State general obligations with a AAA grade have lost 2.3 percent in 2013, compared with a 3.3 percent drop for the broader market, Bank of America Merrill Lynch data show. It would be the first time in five years for the segment to outperform all local debt on an annual basis. The index includes debt from 14 states, including Utah, which sold bonds last week, as well as Maryland and Texas, which plan to borrow this month.

The performance is a reversal from earlier this year, when investors shunned such bonds as the Federal Reserve’s policy of keeping its benchmark lending rate near zero boosted demand for riskier credits with higher yields. The shift is reminiscent of 2008, when the recession and the bankruptcy of Lehman Brothers Holdings Inc. drew buyers to top-rated debt.

“In this kind of market, people would rather have high quality than lower quality,” said Hugh McGuirk, Baltimore-based head of municipal investments at T. Rowe Price Group Inc., which oversees about $20 billion of local debt. “The more quality you have, the better you are.”

Record Revenue

States are recovering from the 18-month recession that ended four years ago, bolstering their haven status. Their tax revenue from January to March rose for the 14th straight quarter, Census Bureau data show. States’ combined collections this year will surpass the record of $670 billion from 2008, according to Todd Haggerty, who tracks budget issues for the Denver-based National Conference of State Legislatures.

At the same time, states are restraining spending on capital projects and employees. Standard & Poor’s said in a report last week it sees “limited appetite” from states for more debt. The governments cut 15,000 workers from payrolls in June, the biggest drop since October, and now employ the fewest people since March 2005, Bureau of Labor Statistics data show.

“The revenue has been coming in, but they haven’t been starting a lot of new capital projects, which leads you to believe they’re using those funds to help with pension issues or create rainy-day funds,” said Tim McGregor, who oversees about $30 billion as director of municipal fixed-income at Northern Trust Corp. in Chicago.

Buying Opportunity

With investors pulling record amounts of cash from muni mutual funds, local securities lost 3.3 percent in the three months through June, the most since 2010.

McGregor said last month’s soaring interest rates created an opportunity to buy state general obligations. Yields on benchmark 10-year munis started June at 2.22 percent, and rose as much as 0.73 percentage point on investor bets that the Fed would slow its bond buying.

Texas, which is set to offer about $91 million of general obligations this week, saw its interest rates rise in the past month. The state’s 10-year debt yields about 2.9 percent, data compiled by Bloomberg show. The interest rate reached 3.02 percent last month, the highest this year.

“Some of those state G.O.s that were at attractive yields are probably going to provide good long-term value,” McGregor said.

Utah Evidence

The demand was evident as Utah issued general-obligation bonds last week. The state, one of eight with top grades from the three biggest rating companies, earned yields below AAA munis on debt maturing through 10 years.

The $226 million tax-free offer included a portion maturing in July 2023 that was priced to yield 2.67 percent. That interest rate was about 0.12 percentage point less than on benchmark munis, the data show.

Yields remain below their 20-year average. That means the best returns will still come from segments that are considered less creditworthy than general obligations, said Michael Zezas, head of muni strategy at Morgan Stanley in New York.

“The extra return you can get from high-quality names in sectors that tend to be a little bit riskier are going to do better than owning what you would normally consider to be the cleanest, highest-quality names in the states market,” Zezas said in an interview.

Health Benefit

In an example of the additional yield, health-care bonds rated AA and due in 10 years have an interest rate of 3.51 percent, Bloomberg Fair Value index data show. That compares with 3.11 percent on general obligations with a similar rating and maturity.

One benefit of top-rated general obligations is that they’re easier to trade when individuals pull money from the market, McGregor said. Investors yanked an unprecedented $13.5 billion from all muni mutual funds in the past three weeks, Lipper US Fund Flows data show.

During the selloff, the extra yield investors required to own securities in Bank of America’s broad-market index rather than AAA state debt reached 1.34 percentage points. That was the widest gap in about a year, showing top-grade general obligations outperformed among munis.

Texas joins the Houston-area’s Grand Parkway Transportation Corp. in borrowing this week as muni issuers offer a combined $11.4 billion of bonds, the most in three months.

Grand Parkway’s $2.9 billion offer, the year’s biggest issue, may include debt maturing in as long as 40 years.

At 4.35 percent, yields on benchmark 30-year munis are close to the highest since May 2011. The interest rate compares with 3.63 percent for similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 120 percent, close to a 12-month high. The greater the figure, the cheaper munis are compared with federal securities.

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