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Buy Signal Seen in Worst Losses Since Whitney Panic: Muni Credit

Meredith Whitney Advisory Group CEO Meredith Whitney
In a Bloomberg Radio interview, Meredith Whitney Advisory Group Chief Executive Officer Meredith Whitney said she “expected a lot of derision from elected officials” from her statements. “But I didn’t expect it from the municipal-bond community.” Photographer: Patrick T. Fallon/Bloomberg

The biggest losses in municipal bonds since 2010 are signaling to investors at Cumberland Advisors and Wells Capital Management that tax-exempt debt is set to rebound.

The asset managers are betting that the worst is over after the $3.7 trillion market lost 3.4 percent last quarter, Bank of America Merrill Lynch data show. It was the steepest drop since the final three months of 2010, when banking analyst Meredith Whitney predicted “hundreds of billions of dollars” of muni defaults, helping propel 29 straight weeks of fund outflows.

There is a precedent for wagering on gains after mid-year. Munis have advanced in July in 21 of the past 24 years, and in August for 17 years in that period, Bank of America data show.

“July should be technically strong for munis,” said Robert Miller, a senior portfolio manager at Wells Capital in Menomonee Falls, Wisconsin.

Miller, whose firm oversees about $34 billion in munis, said he’s been buying because “the market pulled back too far, too fast.”

Demand from individual investors, who own about 70 percent of local debt, has collapsed as a growing economy fuels speculation the Federal Reserve will slow its bond buying. Investors pulled $4.5 billion from muni mutual funds last week, the most since at least 1992, Lipper US Fund Flows data show.

Rally’s End

The latest selloff helped end a nine-quarter rally in munis, the longest stretch of gains since 1993.

The winning streak began at the start of 2011, as demand recovered following the comments by Whitney, chief executive officer of Meredith Whitney Advisory Group in New York, in an interview on CBS Corp.’s “60 Minutes.” The default forecast proved incorrect.

In a June 7 Bloomberg Radio interview, Whitney, 43, said she “expected a lot of derision from elected officials” from her statements. “But I didn’t expect it from the municipal-bond community.”

Yields on 10-year AAA munis reached 2.96 percent last week, the highest since April 2011, as institutional bondholders such as mutual funds offered as much as $1.96 billion for sale, the most in at least 17 years.

Rebound Sign

Local debt has already begun to rebound, gaining the last three trading days in June and pushing the benchmark 10-year yield down to 2.78 percent.

The market for state and city debt usually gains this month because the amount of bond sales from local governments is dwarfed by the money investors get back from coupon and principal payments.

This year is no different -- the cash wave to bondholders this month is set to exceed new issuance by $22 billion, the most since July 2012, according to Citigroup Inc.

“The muni asset class seems oversold and undervalued,” John Dillon, chief muni strategist at Morgan Stanley Wealth Management, wrote in a June 27 report. “The recent spike in yields represents a better time to buy bonds.”

Muni investors saw an opportunity in Illinois, the lowest-rated U.S. state, which received $9 billion of orders for $1.3 billion of general obligations issued on June 26. The biggest portion of the sale was $260 million of uninsured bonds maturing in July 2038. The debt was priced at a yield of 5.65 percent, equivalent to a 9.4 percent taxable yield for buyers in the top federal income-tax bracket.

Loading Up

Those levels were attractive enough for Cumberland, which bought the state’s general obligations after not owning any for more than a year, according to John Mousseau, director of fixed income at the Sarasota, Florida-based company.

“We are taking advantage of this very opportunistic time,” David Kotok, chief investment officer at Cumberland, which oversees about $2.2 billion of munis, said in an e-mail. “We are on the buy side of tax-free bonds. They are cheap. It is time to back up the truck and own them.”

The pattern of July gains could be jeopardized by continued outflows from mutual funds, said Chris Mauro, head of muni strategy at RBC Capital Markets in New York. Even with $45 billion in redemption and coupon payments in June, tax-exempt debt still declined, he said.

Delayed Sales

July returns may also be suppressed by issuers coming to market after canceling or delaying sales as interest rates soared, Dillon said. About $3.1 billion of borrowings were listed as day-to-day or week-to-week last week, data compiled by Bloomberg show.

Localities are set to sell $2.9 billion this week, the least since January. The market is closed July 4 for the U.S. Independence Day holiday.

Interest rates on municipal debt still exceed those on Treasuries, for which the 10-year yield is about 2.5 percent.

The ratio of the yields, a gauge of relative value, rose to 112 percent last week, close to the highest since August. The average since 2001 is about 92 percent. The bigger the figure, the cheaper local debt is relative to federal securities, and the more attractive munis are to taxable investors.

“Ratios around 110, 115 percent of Treasuries is a historical anomaly -- there’s no justification for that,” said Vikram Rai, a fixed-income strategist at Citigroup in New York. “I’m bullish on munis.”

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