The $3.7 trillion municipal market is off to its strongest start in five years as demand for tax-exempt debt rises and issuance falls to the least since 2011.
State and local securities have gained 3.6 percent this year, the biggest first-quarter rally since an advance of 4.4 percent in the opening months of 2009, Bank of America Merrill Lynch data show. In comparison, Treasuries have earned 1.7 percent and corporate debt 3 percent since Jan. 1.
The muni gains are defying predictions heading into 2014 of a second straight year of losses, after a 2.9 percent decline in 2013. Yields have dropped as demand has recovered, with investors adding to muni mutual funds for nine of 11 weeks this year after an unprecedented withdrawal streak. At the same time, localities have curbed borrowing. Bond sales this quarter are the least in three years, data compiled by Bloomberg show.
“Supply remains light, and the big change in the new year is that demand hasn’t been as negative,” said Guy Davidson, who manages $30 billion as director of munis in New York at AllianceBernstein Holding LP. “Yields are still low by historical standards, and people are scratching their heads trying to figure out where to go now.”
The rally puts muni yields in line with their five-year average as investors grapple with competing forces that may determine whether bond prices rise or fall in coming months. While the consensus is for interest rates to climb as the economy strengthens, rising federal tax rates are adding to demand for local debt.
The median forecast in a Bloomberg survey of 65 analysts is that 10-year Treasury yields will be about 0.8 percentage point higher in 12 months.
Michael Zezas, chief muni strategist at Morgan Stanley (MS) in New York, wrote in a report this week that returns are set to “cool off” in coming months as yields rise.
Yet less than three weeks before the deadline for filing individual tax returns, tax-exempt securities may gain appeal as some top earners face levies on debt interest payments that are as much as 24 percent higher than for 2012.
State and local debt is paring its quarterly gain this month. The market has lost about 0.1 percent since Feb. 28, on pace to decline in March for the sixth straight year.
If history is any guide, it could signal a buying opportunity. Of the 15 times munis have posted negative returns in March since 1989, the bonds have rebounded 11 times with gains in April, Bank of America data show.
Munis typically fall in March in part because localities ramp up borrowing, issuing about $31 billion on average, second only to June’s $32 billion, according to Bloomberg data that began in 2003. Even with issuance increasing to $27 billion this month from about $14 billion in February, first-quarter sales may only tally $59 billion, the least for the period since 2011.
Bond sales dwindled to start that year after the federal Build America Bonds program expired at the end of 2010. Yields also rose after banking analyst Meredith Whitney’s December 2010 erroneous prediction of “hundreds of billions of dollars” of municipal defaults in the following 12 months.
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