March 28 (Bloomberg) -- The $3.7 trillion municipal market is off to its strongest start in five years, erasing investor losses from 2013 and providing localities a chance to lock in borrowing costs near generational lows.
State and city securities have earned 3.6 percent this year through March 26, the biggest first-quarter rally since a gain of 4.4 percent in the opening months of 2009, Bank of America Merrill Lynch data show. The debt has advanced in part because bond issuance this quarter was the slowest in three years, data compiled by Bloomberg show.
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 the past 12 weeks after an unprecedented withdrawal streak.
“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 leaves muni yields near five-decade lows as investors grapple with competing forces that may determine whether bond prices rise or fall in coming months. For localities looking to issue bonds, the question is how long the reduced borrowing costs will persist.
While the consensus is for interest rates to climb this year 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 in New York, wrote in a report this week that returns are set to “cool off” in coming months as yields rise.
The bank’s most-likely scenario is that munis post an annualized loss of 1 percent over the next three quarters.
Yet as the April 15 deadline for filing individual tax returns approaches, 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.
The demand has played out in bond sales in California, where voters in 2012 boosted tax rates on income above $250,000. Those making $1 million or more pay 13.3 percent, the most of any state.
The most-populous U.S. state increased the size of a general-obligation offering this month to about $1.8 billion from a planned $1.6 billion. When its public works board borrowed this week, investors demanded less extra yield on 20-year securities than in a November deal, Bloomberg data show.
Individual investors bought about 62 percent of the general obligations and 40 percent of the public-works deal, according to Tom Dresslar, a spokesman for California Treasurer Bill Lockyer.
“The market from an issuer’s standpoint has performed well better than expected for the first part of this year,” he said in an interview.
Puerto Rico and Chicago also increased the size of offerings this month. The Caribbean commonwealth’s $3.5 billion general-obligation sale was the biggest-ever muni high-yield deal.
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 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.
Even though issuance may be ebbing, investors shouldn’t expect the pace of first-quarter gains to persist, said Jamie Pagliocco, director of bond managers in Merrimack, New Hampshire, at Fidelity Investments, which oversees $28 billion in munis.
“It feels like we’re set up pretty well technically -- supply is down, flows are positive,” he said in an interview. “But I wouldn’t anticipate that the market has the ability to continue to rally at the pace it has been.”
Longer-dated munis have led the rally. The extra yield buyers demand to own 30-year bonds instead of two-year debt fell yesterday to 3.24 percentage points, the least since June, Bloomberg data show. The spread widened last year as investors speculated interest rates would rise.
The gains this year show that bet was misplaced, and investors should consider forecasts for higher yields in that context, Davidson said. Benchmark 30-year munis yield 3.7 percent, down from 4.23 percent at year-end.
“Bonds are an important part of peoples’ portfolios,” he said. “If you were afraid of rising rates, and went and hid in a money market, you got zero income and you missed the first-quarter rally.”
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