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Muni Returns to Fade as Interest Rates Rise, Morgan Stanley Says

Returns in the $3.7 trillion municipal bond market are set to “cool off” amid rising interest rates, according to Morgan Stanley analysts led by Michael Zezas.

State and local bonds have earned about 3.4 percent this year through March 24, after a 2.9 percent decline in 2013, according to Bank of America Merrill Lynch data. The 2013 loss was the first for the $3.7 trillion market since 2008. Benchmark 10-year muni yields set a one-month high of 2.59 percent yesterday, data compiled by Bloomberg show.

Ten-year Treasury yields, at about 2.74 percent, should reach 3.3 percent in the fourth quarter as the economy strengthens, according to the report released yesterday by the New York-based bank. Zezas’s most-likely scenario is that munis post an annualized loss of 1 percent over the next three quarters.

“As the economy transitions to a higher growth channel, we expect some more pain from rising rates before valuations become attractive,” Zezas wrote.

If state and local bonds decline this year, it would be the first back-to-back annual losses in more than three decades.

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