Munis Face Unprecedented 2-Year Drop, Morgan Stanley Says

Investors in the $3.7 trillion municipal market will probably face negative returns in 2014 following declines this year, the first back-to-back annual losses since at least the 1980s, according to Morgan Stanley.

The company’s base-case scenario for city and state debt in 2014 calls for a loss of 1.7 percent to 4.1 percent, Michael Zezas, the bank’s chief muni strategist, said in a report released today. A year ago, he correctly predicted that munis would lose money in 2013 as yields rose from the lowest since the 1960s.

The municipal market declined about 2.7 percent this year through Dec. 2, on pace for the first drop since 2008, Bank of America Merrill Lynch data show. Another drop in 2014 would be unprecedented -- local debt has followed a year of losses with gains every year since at least 1989, when Bank of America data begin.

“A painful 2013 yielded better valuations, but more must be endured before our outlook brightens,” wrote Zezas, whose bank is the nation’s sixth-largest by assets. Munis are “disposed to negative returns and volatile liquidity as the economy improves and rates rise,” he said.

Morgan Stanley’s most likely scenario assumes Treasury yields rise as the Federal Reserve tapers its monthly fixed-income purchases. Muni yields reached a two-year high in September after Fed Chairman Ben S. Bernanke signaled that the central bank might curb its buying faster than investors anticipated.

The best-case scenario for state and local bond returns is if the U.S. “is unable to break out of its current slow growth channel, but continues to avoid recession,” Zezas said. In that case, munis could earn 3.5 percent to 6 percent, he said.

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