Feb. 21 (Bloomberg) -- The municipal market is beating a broader U.S. fixed-income rally as states and cities borrow at the slowest rate since 2011. If history is any guide, March will bring a reversal.
Municipal debt has gained about 2.8 percent this year, compared with 1.5 percent for Treasuries and 2.1 percent for corporate securities, Bank of America Merrill Lynch data show. The lack of new debt has buoyed the gains: States and cities borrowed $26.4 billion through Feb. 14, down 28 percent from the same period of 2013 and the least in three years, data compiled by Bloomberg show.
After the worst year for munis since 2008, investors have returned to the market, adding money to local-debt mutual funds in five of the past seven weeks, Lipper US Fund Flows data show. The 2014 gains may be fleeting as issuers led by Puerto Rico are set to take advantage of benchmark yields near the lowest since June.
“Munis have been able to outperform the rally, which is impressive, and the major driver of that is there are just not a lot of bonds around,” said John Dillon, head of muni strategy at Morgan Stanley Wealth Management in Purchase, New York. “The total return we’re seeing now, I wouldn’t get too attached to it. We’re going to see supply pick up.”
Municipalities have historically ramped up bond sales in March, issuing about $31 billion, second only to the $32 billion average for June, according to Bloomberg data that began in 2003. By comparison, average borrowing is $23 billion in February and $19 billion in January.
Investors in the $3.7 trillion municipal-bond market have been burned in March by rebounding supply. Local debt has declined in March for five straight years, the longest stretch of any month, Bank of America data show.
Local governments have been reluctant to start up projects as they mend their finances more than four years after the end of the longest recession since the 1930s.
The fiscal stress may be ebbing. New York, California and Florida are among states that project surpluses as tax collections nationwide have grown for 15 straight quarters, Census Bureau data show.
At the local level, cities forecast their first revenue increase since 2006, according to the Washington-based National League of Cities. All but seven of 363 metropolitan areas will see economic gains this year, according to a report released last month by the U.S. Conference of Mayors.
Led by Puerto Rico, which plans to offer about $2.86 billion of debt next month, states and localities have set $8 billion of bond sales over the next 30 days, according to data compiled by Bloomberg. That’s close to the highest level this year, and up from a 2014 low of $3.4 billion on Feb. 14.
The deal Puerto Rico officials have announced would be the island’s first such sale since 2012, Bloomberg data show.
“March is traditionally a weaker month for municipal debt, and it may be the case this year,” said Tim Heaney, a senior portfolio manager at Hartford, Connecticut-based Virtus Investment Partners, which oversees about $1 billion in munis. “But limited supply might mute some of the traditional weakness.”
The borrowing drop has been a boon to some issuers. Illinois, the lowest-rated U.S. state, lowered yields this month on a $1.03 billion offering after receiving $5.5 billion in orders, according to a statement after the sale. The deal was the municipal market’s largest this year.
As speculation mounted last year that a growing economy would lead the Federal Reserve to curb its bond-buying program, benchmark 10-year muni yields rose 1.1 percentage points, Bloomberg data show. The interest rate has since dropped 0.3 percentage point, to 2.63 percent, leaving it close to the lowest since June.
This year’s fixed-income rally will probably reverse course, according to a Bloomberg survey of analysts. Yields on 10-year Treasuries will rise to 3.4 percent in the last quarter of 2014, from about 2.75 percent now, according to the median forecast of 74 analysts.
At year-end, Michael Zezas, chief muni strategist at Morgan Stanley, and Tom Weyl, director of muni research at Barclays Plc, predicted a second year of negative total returns in 2014, based on the view that interest rates were likely to rise.
The ratio of 10-year muni yields to those on Treasuries has fallen to about 95 percent as local debt has outpaced federal securities, Bloomberg data show. A lower figure means munis are relatively expensive.
“I do expect supply to rise, and I do think we could see higher yields,” Dillon said. “You could see munis underperform from where we are right now.”
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