The fees issuers pay to bankers to underwrite municipal bonds are higher then they’ve been for eight years, as the financial crisis heightened risk and decimated competition in the industry.
State and local governments this year are paying underwriters an average of $6.46 for every $1,000 borrowed, according to Thomson Reuters.
That payment, known as the underwriting spread, is up sharply from last year’s $4.83 average spread.
The last time issuers paid higher fees was 2001.
Underwriters and other market participants cite a number of factors for the fatter spreads, some on the supply side of the equation and some on the demand side.
Spreads compensate the underwriter for a number of things, including the work marketing and placing a bond offering.
The most commonly cited force pushing spreads higher this year is reduced competition in the industry.
The financial crisis last year reshaped Wall Street, and municipal underwriting desks were no exception.
A handful of major banks either went under or were forced into shotgun weddings with other banks. Most of Lehman Brothers was gobbled up by Barclays Capital. JPMorgan ended up with Bear Stearns, Bank of America bought Merrill Lynch, and Wells Fargo bought Wachovia.
The result is fewer underwriters bidding for municipalities’ business.
“There’s fewer bankers trying to get these deals,” said Fred Yosca, head of underwriting and trading at Bank of New York Mellon. “There’s less competition for the deals that are coming.”
“The demise of a large number of broker-dealers in the Street has caused a lack of competition,” said an underwriter in New York who asked not to be named. “You have fewer people underwriting. It allows people to charge a little bit more.”
The introduction of Build America Bonds has also contributed to wider spreads.
Created under the stimulus act, BABs allow municipalities to sell taxable munis and in lieu of the traditional tax exemption receive a subsidy from the federal government equal to 35% of the interest costs.
Issuers have sold $26.75 billion of BABs since the launch of the program in April, according to Bloomberg LP.
Bankers have charged more to underwrite BABs — an average of $8.04 per $1,000 face, compared with $6.27 for other munis, according to Thomson.
The crisis also knocked out a pillar of demand in municipals.
Earlier this decade, a group of hedge funds was buying munis to arbitrage what they perceived as irrationally high yields on long-term munis.
The arbitrage strategy required a complex hedging system using derivatives. The hedges assumed a stable relationship between tax-exempt yields and certain taxable yields, like the London Interbank Offered Rate or Treasury yields.
The flight to safety last year disrupted these relationships and many of the funds were forced to liquidate their positions after the hedges failed. As a result, a major contingent of buyers for munis vanished.
“They were really driving the demand side of the equation,” Yosca said of the municipal arbitrage funds. “That buy-side component seems to be a thing of the past now, so you’ve got to find alternative places to put the bonds.”
The disappearance of this class of buyers had a twofold influence on spreads.
One, underwriters have to work harder to find buyers to replace the arbs. Two, underwriters face a greater risk that they will not be able to find any takers and be stuck holding unwanted paper. Part of the underwriting spread is compensation for that risk.
Interestingly, the same dynamic that pushed the arb funds into liquidation makes it more damaging for underwriters to be burdened with unsold inventory.
Phil Fischer, head of muni strategy at Bank of America-Merrill Lynch, said it is not only that being saddled with unsold bonds is now more likely. It is also more costly.
Until last year, when an underwriter was stuck with unsold munis, he could hedge his inventory with Treasuries or Libor.
In the 25 years leading up to the Lehman bankruptcy last September, the five-year Treasury yield moved at a correlation of almost 0.9 with the five-year triple-A yield. The weakest correlation over any 52-week period during that time was 0.64. A correlation of 1 is perfect, implying identical magnitudes of fluctuations.
An underwriter who had a five-year triple-A muni in his inventory might worry that the price would decline before he could sell it.
Because of the strong correlation between the muni and the Treasury, he could buy a derivative that would pay off if the five-year Treasury yield went up. Thus any spike in yields on the muni would be mostly offset by a jump in the value of the Treasury yield derivative.
For the same reasons the arb funds went under, that hedge is no longer viable.
Since the Lehman bankruptcy, five-year Treasury yields have mirrored five-year muni yields at an unreliable correlation of 0.31.
That means a future that gains in value when the Treasury yield ascends does not offer much protection against an incline in muni yields. The two no longer move together.
The fatter spread is also compensation for this additional uncertainty, Fischer said.
“Dealer desks are exposed to more risk when they hold municipal bonds because they’re difficult to hedge,” he said.
Add to this the disappearance of most worthwhile bond insurance and the credit-quality concerns over state and local governments, and owning munis is a more dangerous proposition than it was a year ago.
“Because the market was so volatile, underwriters needed more spread to protect their inventories,” said Dan Keating, chief operating officer at Samuel A. Ramirez & Co.
Fischer attributes the plump BAB spreads to the difficulty of marketing a new product to new types of investors.
Further, BABs tend to carry several features investors in the taxable market either dislike or unaccustomed to.
The investors who buy corporate bonds — which is the base BABs are supposed to tap — prefer big issues with bullet maturities, Fischer said.
That is how corporations normally float debt. Municipalities, by contrast, typically sell much smaller batches of debt than corporations, and with serial maturities.
The average BAB deal size is $10.5 million, Fischer wrote in a report this month, while the average size of a bond in the Bank of America-Merrill Lynch double-A corporate index is $1.11 billion.
Municipalities also like to embed their bonds with call options, enabling them to buy back their debt after a certain period, typically 10 years.
Investors in taxables dislike callable bonds, Fischer said.
The discrepancies all make finding buyers harder, he said.
A trader in Los Angeles said he expects the spreads on BABs to narrow in the next few months because investors are embracing the product, making it easier for underwriters.
