Predictions by several municipal experts forecast a 2015 that runs the gamut from a flattening yield curve to increased issuance on the heels of a surprisingly strong year of performance in 2014.
Experts say municipals will see solid demand this year based on strong market technicals, but they are divided over their views on prospective issuance.
"We expect another year of negative net supply supporting valuations in 2015," said Justin Hoogendoorn, CFA and managing director at BMO Capital Markets in a bond market outlook published last month.
His gross projections of $336 billion in 2015 would place issuance just above the $334 billion issued in 2014 according to preliminary data from Thomson Reuters. Hoogendoorn said the projection is primarily due to an increase in capital projects in the improved economic and general low-rate environment. "Supply progression for the coming year may look similar to 2013, with higher overall supply due to refunding activity in the first half of the year."
He also expects an estimated $345 billion in supply taken out of the market in 2015 due to a combination of $157 billion in maturing bonds, $75 billion in pre-refunded bonds with 2015 take-outs, and projected calls of $113 billion in currently refunded bonds.
"These totals suggest a fairly balanced supply outlook, with negative $9 billion net and only marginally less favorable than last year's negative $27 billion," Hoogendoorn said.
While refunding volume might be pressured by rising rates, new money issuance should be buoyed by improving fiscal conditions at state and local levels, said David Litvack, head of tax-exempt fixed income research at U.S. Trust in a December interview.
But Dorian Jamison, municipal analyst at Wells Fargo Advisors, said issuance could be impacted by a combination of political issues, including the conservative-heavy mid-term elections.
"I would say that based on the trends we have seen in 2014, I expect supply will be somewhat down based on ongoing sequesters, and programs will remain limited," Jamison added.
"That could play into a limit in new issuance of supply going forward," Jamison said.
Patrick Early, chief municipal analyst at Wells Fargo Advisors, said more fiscal improvement by states and local governments is needed before bonding programs will increase in 2015.
"I do not see a lot of states and locals that feel comfortable with their financials to embark on infrastructure financing," Early said. "There is not a lot of push toward bonding programs, or a lot of impetus to issue a lot of debt to start the year," Early said.
Anthony Valeri, municipal strategist at LPL Financial Inc., said he believes 2015 will see slightly more volume, but "I don't think the increase in new issuance will be enough to really move the needle."
He predicts issuance between $310 billion and $320 billion based on stronger state budgets and more capacity to issue debt, including some refunding deals, but at the same time, said he would not be surprised by another net-negative supply year, albeit marginal.
"Municipals could likely benefit from another year of limited supply," Valeri said. "Demand will be elevated creating a favorable supply-demand balance."
In either case, experts say volume will be slow to start off the year.
2015 should be characterized by the same seasonality with respect to supply and demand as it typically does, according to Phil Fischer, head of municipal bond research at Bank of America Merrill Lynch.
He expects issuance to be very light in the first few weeks in January, followed by a heavy rollover during redemption season in June and July, and weaker periods in March and April, and October and November.
"Demand will remain relatively strong and we should begin the year on pretty good footing barring unforeseen issues we can't predict," Jamison said. "The technicals all continue to be in the market's favor to begin the year," he said.
"The muni market has been a good place for individuals who are long-term holders" of bonds, Fischer said. "There was some volatility because of flows, but the credit structure of the market has remained intact," he said, predicting 3.3% gross domestic product growth this year that could later lead to a 7% growth in state revenues.
Alan Schankel, managing director of credit research at Janney Montgomery Scott, expects mutual fund flows to continue to be steady in 2015, due to stabilizing credit conditions - with Detroit and Stockton, Calif., bankruptcies in the rearview mirror - and since the tax-advantages of municipal bonds are attractive in a backdrop of low yields and the highest top tax bracket since 1986.
"The tax-adjusted income story in the municipal markets remains a big source of likely outperformance, while low new-money issuance means that municipal-to-Treasury ratios could fall to the low 80% area," Schankel said in December report.
In the debate over rising interest rates, municipal experts say the timing will hinge on economic and political factors in 2015.
"We are expecting the Fed to keep rates close to zero through the first half of 2015," Fischer said in a recent interview.
Likewise, Litvack said he expects the improving economy to prompt an interest rate hike somewhere in mid-2015. "We are pretty bullish on the U.S. economy," Litvack said. "In general, we are also bullish on credit because of the generally improving conditions."
He tends to avoid credits that have lagging economies and structurally unbalanced budgets, as well as large unfunded pension obligations.
"Fed policy is again the single biggest variable, and while the markets are pricing in a high probability of a first hike in June 2015, that date is far from certain and the first hike could be into 2016, Schankel wrote.
Early, however, was less convinced of the potential for a rate hike. "You'd need to see something on the inflation front, and several months of solid job report numbers" before rates rise in 2015, Early said.
Meanwhile, Peter Hayes, managing director of the municipal bond group at BlackRock, expects any Fed tightening to be confined to the front end of the yield curve, and said the recent job growth has been enough to lead a potential Fed rate-raise by mid-2015.
"When the Fed does raise rates, it's the front of the curve that bears the brunt of that," Hayes said.
In the meantime, Hayes expects most of the value and income to be found in long intermediate maturities between 12 and 20 years, without the duration risk of buying 30 years.
Indeed, there will be more focus on high-quality credit as investors adopt a cautious stance while minimizing potential volatility in the backdrop of a flatter yield curve and rising rates in 2015, according to Karissa McDonough, director of the fixed income strategy for People's United Bank Wealth Management.
"The volatility in rates that the bond market has been experiencing is something that will likely continue for the intermediate term, meaning that investors need to manage duration and interest rate exposure based on economic information," she said.
She said she expects the Fed to ring in the New Year by tightening monetary policy for the first time since the financial crisis through hiking the Fed Funds Rate.
"This means that the municipal bond market may potentially experience flows away from stretching for yield and back into higher-quality municipal issuers as interest rates begin to normalize," McDonough said. Her investment management firm oversees $5.5 billion in assets.
Hoogendoorn said the expected flattening yield curve in 2015 may drive a greater share of borrowing to the long end of the curve, which will appear more attractive to issuers. "Alternatively, it could place some upward pressure on the 20- to 30-year area of the curve," he predicted.
Meanwhile, Valeri recommends a mix of intermediate and longer-term municipals as 2015 begins, which he said will provide better value and risk to reward.
"2014 turned out to be a very good year, but I do not expect that to be repeated," Valeri said. "I'm looking for flat to low single digit returns in the muni market," Valeri said. "The muni market is going to take its cues from Treasuries - even if they are more attractively valued they are definitely not as attractive as they were in early 2014," Valeri said.
He said the first rate hike will likely arrive in late 2015 or early 2016 as the market continues to adjust to stronger economic growth and the eventual Fed rate hikes. "We are at a more expensive point to start 2015 which will translate into much lower returns," Valeri added.
Regardless, the markets are clearly under-pricing the risk that the Fed hikes rates later - or even not at all in 2015- which would be of benefit to the intermediate portion of the yield curve, Schankel said in his report. He said municipals represent the firm's strongest overweight call for 2015.
Meantime, others said they recommend being fully invested into the New Year.
"We actually think short duration and cash is not the place to be heading into 2015," Hayes said.
Fischer agreed and said he suggests staying fully invested and diversified.
"We expect the muni market to generally be improving in credit, volatility to be relatively modest, and we think investors are well served by staying invested, rather than holding pure cash," Fischer said. "Investors should ladder out on the short end and as short rates go up, reinvest cash, or take the gains from the roll and stay diversified."
"The muni yield curve is extremely steeply sloped and the cost of staying in cash is very high," Fischer added. "Munis still offer taxpaying individuals a very large windfall," Fischer said. "The U.S. is doing much better, but the rest of the world is not on our page."
Early agreed. "There is still a global element pushing investors to the U.S. fixed income market," he said.
McDonough said short rates are rising as investors are starting to price in the impact of pending Fed rate hikes. At the same time, she said long rates continue to be pushed down as international demand for safe-haven assets continues unabated.
Overall credit will be a hot topic in 2015, according to municipal experts.
Hayes expects to focus on mid-level quality paper, mostly A-rated revenue sectors compared to high-yield, which he called expensive in early December.
"We also believe that muni investors need to be especially cognizant of credit quality in this environment," McDonough said. "Reaching for yield through taking on additional credit risk in the muni space is not a strategy that works in a monetary tightening cycle. In such an environment, weaker municipalities may face additional hurdles to accessing necessary capital, which could lead to adverse credit events such as defaults."
Higher-rated credits have historically experienced significantly lower default rates than lower-rated municipals, McDonough said, and the stronger entities will have the ability and means to "effectively manage fiscal challenges."
Overall, the market should be well-positioned going into 2015, Fischer noted.
On the pension front, Hayes said there will be a greater need to address unfunded pension problems in 2015.
A post-recession gap in new infrastructure financing as well as pension funding needs to be addressed in 2015, according to Fischer. "We are basically saying states have to step up and catch up," Fischer said.
With respect to Puerto Rico, Fischer said the future recovery is uncertain, but there is currently an active market for the debt dominated mostly by hedge funds.
"Most of us think that there will be some restructuring activity for PREPA by the end of the Q1," Fischer said.
Experts said the restructuring shouldn't have a material effect on the market as whole.
Valeri of LPL said much of the market has come to realize that Puerto Rico is an example of a one-off, isolated credit event. "The majority of the muni market is quite healthy and defaults are historically low," he said.
Christine Albano is an investing reporter for The Bond Buyer.
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