Munis Dominate in Yearlong Advance Wall Street Analysts Missed

Municipal-bond investors who ignored the consensus forecast a year ago that interest rates would rise are proving to be the biggest winners in 2014.

Munis have gained 9.4 percent this year through Dec. 24, the most since 2011 and eclipsing the 6.8 percent return for investment-grade company debt and 5.4 percent for Treasuries, Bank of America Merrill Lynch data show. A 0.22 percent December return puts munis on pace to gain in every month of 2014, an unprecedented streak. Longer-dated munis were the year’s best performers -- bonds maturing in at least 22 years have surged 16.5 percent, beating a gain of about 15 percent gain on the Standard & Poor’s 500 index of stocks.

The bond rally wasn’t expected 12 months ago, when the median forecast in a Bloomberg survey of analysts for the current level of 10-year Treasury yields was about 3.4 percent. Instead, the yield sank to 2.25 percent. Looking to 2015, analysts project another year of muni gains, even as interest rates rise from generational lows.

“I’d like to tell you that last December I predicted interest rates were going to go down, but I didn’t: I expected rates to go higher, just as almost everyone else did,” said Alan Schankel, a managing director at Janney Montgomery Scott LLC in Philadelphia.

“I was pleasantly surprised by how well the muni market performed,” he said in a telephone interview. “I don’t expect that kind of return next year, but I do think it will be a positive return, and it’ll be based largely on the coupon.”

Detroit Cloud

Munis lost 2.9 percent in 2013, the steepest decline in five years. With cash flowing in this year, munis rallied anew, pushing benchmark 10-year yields as low as 1.94 percent in October, from 3 percent at the start the year, data compiled by Bloomberg show.

Individuals, the biggest owners of the $3.6 trillion municipal market, returned to tax-exempt debt this year after Detroit’s bankruptcy and Puerto Rico’s economic struggles prompted them to flee in 2013. Investors have added about $21 billion to muni mutual funds in 2014 after extracting a record $63 billion last year, Lipper US Fund Flows data show.

“Munis cheapened up tremendously when we started to have negative fund flows,” said Phil Fischer, head of muni research in New York at Bank of America. “The market is more resilient and more liquid than it’s given credit for.”

Tax Hit

State and local debt may return about 5 percent next year, with investors earning their coupon payments -- often about 4 percent or 5 percent, Fischer said.

The appeal of tax-exempt interest on munis has grown for high earners, who this year faced bills that for the first time included federal tax increases that took effect in 2013: a top marginal rate of 39.6 percent, up from 35 percent; and a 20 percent tax on long-term capital gains and dividends, up from 15 percent. The top bracket is the highest since 2000.

Combined with a 3.8 percent tax on the investment income of top earners resulting from the 2010 Patient Protection and Affordable Care Act, the top federal tax rate reaches 43.4 percent. That means the 2.13 percent yield on AAA 10-year munis is equivalent to a taxable rate of 3.76 percent.

“High-income individuals can tolerate a great deal of bad information before they should not be in munis,” Fischer said.

Considering Losses

Local-debt investors should still brace themselves for subdued returns, and even losses amid rising yields, said Chris Mier, chief municipal strategist at Loop Capital Markets in Chicago.

A flat 2015 is “certainly a possibility, and modest negative total returns certainly have to be considered,” he said in a telephone interview. “As the year progresses, the odds favor an increase in rates.”

The median forecast for 10-year Treasury yields at this time next year is about 3 percent, up 0.75 percentage point from now, according to a Bloomberg survey of 74 analysts. That prediction is down from 3.6 percent in August as yields kept falling.

Michael Zezas, chief muni strategist in New York at Morgan Stanley, predicts 10-year Treasury yields will climb to 2.85 percent a year from now, according to the most-likely scenario in a Dec. 1 report. The bank expects state and local debt to gain 1.14 percent.

A year ago, Zezas was among those who predicted losses in 2014 as interest rates increased. This time around, signs of slowing global growth will keep the lid on Treasury yields, he said in a telephone interview.

“We were obviously wrong about interest rates climbing higher,” Zezas said. Munis will gain in 2015 “because you’re earning the coupon while you’re losing just a little bit on the price of the bonds.”

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