Best Rally Fueled by History Signaling Supply Drop: Muni Credit

The municipal market’s biggest rally since 2004 is paving the way for gains in this year’s final months amid a history of dwindling local-debt supply and bets the Federal Reserve will extend its monthly bond buying.

Munis earned 0.9 percent in October, the best showing in nine years, Bank of America Merrill Lynch data show. The gains defied a pattern of losses in the month and came even as issuance shot to the highest since August.

The rally bodes well for the $3.7 trillion market in the weeks ahead. If the past is any guide, localities won’t sustain last month’s pace of borrowing. Issuance has waned after October in each of the past four years, according to data compiled by Bloomberg. At the same time, outflows from muni mutual funds last week were the smallest since September.

“There is a lot of pent-up demand on the sidelines and supply is anemic at best,” said Vikram Rai, a fixed-income strategist at Citigroup Inc. in New York.

October’s gain drove interest rates on city and state borrowings to the lowest since June. It also ran counter to the record of the past 13 years. Local bonds had lost 0.2 percent on average in the month since 2000, making it the weakest part of the year.

Fed policy makers last week maintained their $85 billion of monthly asset purchases, even as they said the economy showed signs of “underlying strength.” Chairman Ben S. Bernanke’s June hint that he might shrink the buying spurred declines across fixed income. Detroit’s July bankruptcy also fed muni losses.

Rebound Months

Munis rebounded the past two months, the first back-to-back increases since February, and beat Treasuries in both periods, Bank of America Merrill Lynch data show.

The bonds typically have momentum heading into year-end. Since 2000, local debt has gained 0.3 percent in November on average and 0.7 percent in December, Bank of America data show.

Localities typically cut back on issuance in the final two months of the year, helping suppress yields. States and cities have sold fewer bonds in November and December than in October every year since 2008, Bloomberg data show.

The weeks that include the holidays of Thanksgiving, Christmas and New Year’s are historically among the year’s slowest.

Demand Display

The municipal market enters the period with signs of rebounding demand. Individuals withdrew about $503 million from muni mutual funds in the week ended Oct. 30, the least in five weeks, Lipper US Fund Flows data show. In the 21 weeks through Oct. 16, investors pulled a record $55 billion.

The boosted appetite has reduced the ratio of muni yields to those on Treasuries to about 101 percent, from a seven-week high of 111 percent less than two weeks ago, Bloomberg data show. The figure is a gauge of relative value, and a decline indicates local debt has become more expensive in comparison.

That shift indicates to some investors that October’s rally has dimmed the appeal of city and state obligations.

“The word has gotten out that it was a good time to buy munis and it’s not as compelling going forward,” said Paul Mansour, head of muni-credit research at Conning, a Hartford, Connecticut-based asset manager that oversees $9 billion in local debt. “It has been a very strong performance month for munis and the sector is no longer all that cheap.”

Conning has been adding state and local debt rather than other fixed-income securities this year, Mansour said.

Yield Expectations

Yields on 10-year Treasuries will rise to 2.95 percent next quarter from about 2.62 percent now, according to the median forecast of 64 analysts surveyed by Bloomberg last month. That’s down from an estimated 3 percent in a September survey.

The lower forecast is partly a result of expectations that the Fed will keep up the pace of its bond purchases into next year. The Federal Open Market Committee won’t curb the buying until its March 18-19 meeting, according to the median estimate in an Oct. 17-18 Bloomberg survey of economists.

Citigroup’s Rai said the move may not come until April.

“I’d expect a slightly stronger market because tapering has been pushed out,” Rai said. “That has a simulative effect on the fixed-income market and that will keep yields depressed.”

Market Week

Issuers from Hawaii to Massachusetts are set to offer about $6.9 billion in long-term debt this week, up from last week’s $4.9 billion as benchmark yields are close to a four-month low.

The interest rate on AAA 10-year munis is 2.65 percent,

The ratio of the yield to that on similar-maturity Treasuries is the lowest since July, though still above the average of 94 percent since 2001. It has remained above 100 percent since June 24. The higher the figure, the cheaper munis are compared with federal securities.