Tax-Free Bonds Rally Like It’s 1991 in Fund Frenzy

The longest rally in municipal debt in more than two decades is luring cash to mutual funds and pushing asset managers to buy tax-free bonds even with yields close to 11-month lows.

For the first time since 1991, state and local debt has gained in each of the year’s first five months, Bank of America Merrill Lynch data show. The 6.3 percent return through May 26 is better than Treasuries, corporate bonds and the Standard & Poor’s 500 Index.

Benchmark muni yields are near generational lows as demand rises for tax-exempt bonds in the face of higher federal levies while issuers sell the least debt since 2011. Investors have poured $2.2 billion into muni mutual funds in the past three weeks, the most in 16 months, Lipper US Fund Flows data show. Inflows are set to increase as bondholders receive cash from maturing and refinanced securities.

“You have to believe that there’s more room to run,” said Eric Friedland, head of muni research in New York at Schroder Investment Management North America. The firm oversees about $4 billion in local debt. “You have low supply, you have inflows just starting to come into the market right now, and you have high redemptions coming.”

Consensus Defied

Since the start of the year, investors in the $3.7 trillion market have grappled with forces that have driven yields lower in the face of a consensus prediction that interest rates would rise.

Strategists at Morgan Stanley and Barclays Plc said in December that 2014 would bring a second consecutive year of losses. Citigroup Inc. last month advocated selling as yields plunged.

The five-month rally has defied the projections.

Barclays’ Tom Weyl, director of muni research in New York, said in April that conditions still favor munis. In a report last week, he reiterated his view still holds for now.

Citigroup, which in April suggested selling to lock in any 2014 gains, said in a May 16 report that the supply-demand imbalance means munis may extend their advance.

“Investors are paranoid for missing out on the rally, so they throw more money at the rally,” Vikram Rai, a fixed-income strategist at Citigroup in New York, said in an interview. “Maybe it makes more sense for investors to ride it out than wait on the sidelines.”

Demand Driver

Michael Zezas at Morgan Stanley said in an interview last week that it’s possible for the forces driving returns to persist, though the potential for gains is waning.

One reason for a sustained rally is the money that investors are about to receive from maturing and refinanced bonds. The $92 billion wave in the three months through August will exceed issuance by about $20 billion, according to Citigroup.

That means demand will exceed debt available through the primary market, assuming bondholders want to reinvest in munis. For all of 2014, bond calls and redemptions will probably top new deals by $70 billion, according to Citigroup.

Municipalities have borrowed $102 billion this year through May 23, the slowest pace since 2011 and down from $138 billion at the same point of 2013. Some states are capitalizing on the dynamic: Connecticut refinanced debt this month, lowering costs by a record $95 million over 11 years.

Unaltered Equation

Janney Montgomery Scott LLC projects issuance will fall to as low as $175 billion in 2017. The call is based on forecasts of rising interest rates. Yet bond deals have slowed this year even as yields declined.

Last year, states increased net tax-supported debt by 0.4 percent, the least in 20 years, according to a Moody’s Investors Service report. That compares with a 6.5 percent average growth rate for the past decade.

“There’s not much reason to be concerned about a ton of supply or anything that’s going to disrupt the equation,” said Tim McGregor, director of municipal fixed income in Chicago at Northern Trust Corp., which oversees $30 billion of local debt. “Munis are probably attractive enough to get a lot of buyer reinvestment.”

The appetite for fixed income flies in the face of consensus projections. The median forecast in a Bloomberg survey of 63 analysts is for 10-year Treasury yields to be about 1 percentage point higher in a year as the economy strengthens.

‘One-Way Street’

“It has been a one-way street,” said Zezas, chief muni strategist at Morgan Stanley in New York. “We do still expect that rates will rise and that returns will probably be softer than they have been.”

The return on state and local debt compares with 3 percent earned on Treasuries, 5.2 percent on corporate bonds and 4.3 percent on the S&P 500, when including dividends.

Benchmark tax-exempt munis maturing in 10 years yield 2.3 percent, close to an 11-month low, Bloomberg data show. Yet on a taxable-equivalent basis for top earners, the rate is about 3.8 percent. That compares with an interest rate of about 2.5 percent on similar-maturity Treasuries.

Higher earners are reconsidering munis after seeing their tax bills rise last month, said Justin Land, who helps manage $3 billion of munis at Naples, Florida-based Wasmer, Schroeder & Co. Some filers faced taxes on debt interest payments as much as 24 percent higher than in 2012.

In 1991, when S&P still rated Detroit general-obligation bonds investment grade and had Puerto Rico’s debt five steps below AAA, the five-month rally halted in June. Munis still went on to earn 12.6 percent that year, the fourth-best of the past quarter-century.

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