Puerto Rico Could Roil Munis as Investors Unload, Citigroup Says

The municipal market’s strongest start since 2009 may be in jeopardy as developments in Puerto Rico bonds increase price swings, Citigroup Inc. said.

The Caribbean commonwealth and its agencies, which have about $73 billion in debt, sustained credit cuts from the three biggest rating companies this month. The downgrades deeper into junk and ensuing price declines prompted investors to yank $790 million from muni mutual funds in the week through July 9, the most since January, Lipper US Fund Flows data show.

Volatility has risen in the past two weeks. Benchmark 10-year muni yields set a three-month high last week, then fell today to 2.33 percent, the lowest since June 9, data compiled by Bloomberg show. Meanwhile, Puerto Rico securities are rebounding, for the longest winning streak since May, according to S&P Dow Jones Indices.

Losses in Puerto Rico bonds “have the perceived potential to roil the entire municipal market and thus negate the positive returns generated by municipals year-to-date,” Citigroup strategists George Friedlander, Mikhail Foux and Vikram Rai wrote in a report published yesterday.

“Municipal investors should buckle down for some short term pain and volatility,” the New York-based strategists wrote. Puerto Rico combined with the potential for a broad increase in interest rates across fixed-income could spur instability similar to the period after banking analyst Meredith Whitney’s incorrect default prediction in December 2010, they said.

Treasuries Trounced

The $3.7 trillion market for state and local debt is off to its strongest start since 2009, gaining 6.3 percent, Bank of American Merrill Lynch data show. That’s better than Treasuries and corporate securities, which have earned 3 percent and 5.9 percent, respectively. Munis have defied predictions of a second straight year of losses in 2014.

Yet munis have trailed Treasuries in July, on pace for the first month of underperformance since August 2013.

“The best period of municipal performance is over for the year,” the strategists wrote. The market will still probably generate a positive total return in 2014, they said.

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