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 Barring an unforeseen turnaround in the final weeks of 2013,
municipal bonds will post their first negative annual performance
since the financial crisis, with investors fleeing municipal funds
at a record pace and the market's overall size, now less than $3.7
trillion, contracting for a third straight year.
Analysts, portfolio managers and traders say concerns about the
Federal Reserve scaling back its massive stimulus, and about the
financial soundness of state and local governments, will keep
hitting the market at least through the first half of next year.
They expect debt issuance to fall further and investors to continue
exiting bond funds.
"There are two themes that occurred this year and they're going to
carry on to next year," said Chris Alwine, head of municipal bonds
at The Vanguard Group, which has $100 billion in assets. "The big
news in the muni market was the back-up in rates and the
underperformance of the long end of the curve."
Municipal bond yields shot up this year on the Federal Reserve's
talk about tapering its monthly purchases of Treasuries and
mortgage-backed securities, news of Detroit's bankruptcy filing and
Puerto Rico's budget woes. Demand plummeted as investors moved into
more promising equities. Supply followed, with outstanding municipal
debt hitting its lowest level in nearly four years.
As for performance, the Bank of America Merrill Lynch master
municipal index has fallen 2.84 percent this year, putting the
market on track for its first negative total return since 2008. Its
index of bonds with maturities 22 years or more is down nearly 6
percent.
"Altogether, 2014 will likely be another down year for munis," wrote
Thomas Weyl, credit analyst for Barclays Capital in a note. "As we
contemplate the taper and rising interest rates, as well as
continued municipal mutual fund outflows ... it is hard to see the
light at the end of the tunnel."
BOND SALES SEEN DECLINING, FUND OUTFLOWS PERSISTING
Total municipal issuance will likely tumble to $349.5 billion in
2014 from the $366.1 billion it projects for this year, according to
the Securities Industry and Financial Markets Association's (SIFMA)
recent survey of 11 underwriters and dealers, one of several
forecasts for a drop in bond sales.
"Although the overall systemic credit quality of the municipal
market is strong, state and local issuers remain pressured by a
moderate recovery, and the refunding wave has waned," said Michael
Decker, head of SIFMA's Municipal Securities Group.
Rising yields have ended the savings issuers could reap through
refinancing existing bonds. Sales of refunding bonds are running 30
percent lower than last year and depressing total issuance,
according to Thomson Reuters data.
In fact, sales may not even meet SIFMA's projections for 2013. As of
Friday, total issuance for the year was $303.66 billion and sales
are only expected to reach $2.5 billion next week.
"In the growth years, 2000 to 2010, you had debt for new
infrastructure growing significantly and you had refunding," said
Chris Mier, managing director of analytical services at Loop
Capital, which forecasts 2014 issuance only at $300 billion. "Now
you're seeing ... new money volume for these infrastructure projects
flat because of the political environment and the aversion for
taking out new debt."
On the demand side, net outflows from muni funds — which have
already hit a record $52.76 billion this year — could persist for
three to six months, said Vanguard's Alwine.
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Outflows during the third quarter alone, $32 billion, exceeded total
net outflows of any entire year going back to 1992, according to
Lipper, a Thomson Reuters company.
Many funds hold Puerto Rico bonds because they are exempt from state
and federal taxes, and some outflows were driven by the territory's
budget woes. Detroit's bankruptcy filing — the largest municipal one
in U.S. history — also led to outflows.
Still, "maybe 80 percent was driven by fears of interest rates going
higher," said BlackRock Managing Director Peter Hayes, who heads the
firm's municipal bonds group.
There will likely be a modest uptick to start the year, as coupon
payments and maturing bonds often give investors cash to put back
into funds or individual bonds each January, Hayes said, "but I'm
not sure how large or sustained they'll be."
CLARITY FROM THE FED
The Fed's discussion of tapering, which will ultimately lead to
rising borrowing costs, is also pushing investors into shorter-term
funds, said Michael Rawson, fund analyst for Morningstar Inc. Only
two of the 16 municipal bond fund categories the investment research
group tracks had inflows this year, with the larger inflow in the
short-term category.
"The reaction to the prospect of tapering among retail investors has
been pretty violent," said David Santschi, CEO of TrimTabs
Investment Research, adding $164.5 billion has left the funds since
the start of June. "What will happen when the Fed actually takes
action?"
Most on Wall Street expect the Fed to hold off reducing its bond
purchases until the first quarter, but there is some risk the
central bank could move as early as its meeting next week. Either
way, the meeting is expected to bring some clarity to the Fed's
timeline.
In the past, municipal bonds outperformed Treasuries when the Fed
tightened the money supply, and several analysts look for that
scenario to play out again, with some market players eyeing
opportunity among the municipal market's fat yields, especially
relative to other corners of the bond market.
Currently, highly rated 30-year bonds are yielding 4.16 percent on
the benchmark scale set by Municipal Market Data, a Thomson Reuters
company, compared with a 30-year Treasury yield of just 3.87
percent. Add in their tax-exempt qualities, and they look even
cheaper by comparison.
"Some of the hysteria from 2013 has and will continue to yield good
buying opportunities that will benefit from spread compression, even
if rates continue to drift higher," said Michelle Knight, chief
economist and managing director of fixed income for Banyan Partners,
LLC.
(Reporting by Lisa Lambert; editing by
Dan Burns and Nick Zieminski)
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