Analysis: Little respite seen for U.S. municipal bonds in 2014

Sun Dec 15, 2013 7:04am EST
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By Lisa Lambert

WASHINGTON (Reuters) - The withering U.S. municipal bond market will shrink even more well into 2014, with interest rate and credit risks keeping both investors and borrowers away.

Barring an unforeseen turnaround in the final weeks of 2013, municipal bonds will post their first negative annual performance since the financial crisis, with investors fleeing municipal funds at a record pace and the market's overall size, now less than $3.7 trillion, contracting for a third straight year.

Analysts, portfolio managers and traders say concerns about the Federal Reserve scaling back its massive stimulus, and about the financial soundness of state and local governments, will keep hitting the market at least through the first half of next year. They expect debt issuance to fall further and investors to continue exiting bond funds.

"There are two themes that occurred this year and they're going to carry on to next year," said Chris Alwine, head of municipal bonds at The Vanguard Group, which has $100 billion in assets. "The big news in the muni market was the back-up in rates and the underperformance of the long end of the curve."

Municipal bond yields shot up this year on the Federal Reserve's talk about tapering its monthly purchases of Treasuries and mortgage-backed securities, news of Detroit's bankruptcy filing and Puerto Rico's budget woes. Demand plummeted as investors moved into more promising equities. Supply followed, with outstanding municipal debt hitting its lowest level in nearly four years.

As for performance, the Bank of America Merrill Lynch master municipal index has fallen 2.84 percent this year, putting the market on track for its first negative total return since 2008. Its index of bonds with maturities 22 years or more is down nearly 6 percent.

"Altogether, 2014 will likely be another down year for munis," wrote Thomas Weyl, credit analyst for Barclays Capital in a note. "As we contemplate the taper and rising interest rates, as well as continued municipal mutual fund outflows ... it is hard to see the light at the end of the tunnel."


Traders work on the floor of the New York Stock Exchange December 12, 2013. REUTERS/Brendan McDermid