Bond dealers expect 2014 to be the second-worst year for municipal issuance in a decade, and some predict the lowest volume since 2000, as the Federal Reserve's tapering program pushes interest rates higher.

Gross new issue volume this year will total $296 billion, down 10% from $330 billion in 2013, according to the median estimate of seven leading municipal bond underwriters. That would rival 2011's volume of $287 billion for the lowest yearly issuance since 2002.

A decline in bond refundings will be the main culprit, market analysts said, as climbing interest rates make it less attractive to replace existing bonds with new debt.

"The biggest variable is what happens to interest rates," Chris Mauro, head of municipal research at RBC Capital Markets, said in an interview. "A gradually rising interest rate environment won't have that much of an impact on new money issuance but it will suppress refunding activity."

Refunding issuance will make up $98.6 billion of issuance in 2014, a decline of 11% from the $111.1 billion of refunds in 2013, dealers estimated. New money is expected to be $195 billion, up 22% from $159.2 billion in 2013.

"We think there is a little bit of pent up demand there and that the economy will be modestly improving next year, bumping up new money issuance," Mauro said.

The improving U.S. economy is a double-edged sword, researchers and analysts said. On one hand, economic growth and growing populations in some areas provides more income for states and municipalities, bolstering their ability to take on new projects. At the same time, a healthier economy gives the Fed reason to slow down its bond buyback program, which pushes interest rates higher.

"Forecasting where total volume is going to be is more art than science," Natalie Cohen, managing director at Wells Fargo Securities, said in an interview. "It's a hard number to come up with, and it's based on what happens with treasuries."

The 10-year U.S. treasury yield, currently at 2.89%, may rise to 3.60% by the fourth quarter of 2014, RBC's Mauro said. The ratio of municipal to treasury yields will rise significantly in the first quarter of 2014, according to Peter DeGroot, a managing director at JPMorgan.

"We expect ratios to maintain their relative low levels over the near term," DeGroot, head of JPM's municipal research, said in an interview. "They're relatively rich to their recent averages and we think they can maintain that for some time."

Taxable municipal bonds that rallied in the latter half of 2013 could cheapen as yields increase, DeGroot said in a JP Morgan outlook report. Many issuers favor the bonds over tax-exempt credits due to the flexibility with which the proceeds can be used.

"Taxable issuance is trending higher and it appears there is a decent incentive for some issuers to exploit the taxable market over the tax-exempt one," DeGroot said. "There tend to be less regulatory restrictions and a less onerous path to issuance for taxable securities."

Municipal yields spiked after the Fed announced it would slow its bond buying program in May, and then declined as details surrounding the implementation of the Fed's taper remained murky.

A U.S. government jobs report on Jan. 10 sent bond yields lower, indicating to some market participants that the tapering program may move slowly. The yield on the 10-year AAA bond has declined 15 basis points to 2.64% since Jan. 2, according to Municipal Market Data. The 30-year yield has risen three basis points.

"Some parts of the market are priced ridiculous cheap after a horrible 2013," Mikhail Foux, a municipal strategist at Citigroup Global Markets, said in an email. "We expect muni rates to be only marginally higher."

Outflows from municipal bond mutual funds, which declined to just $19 million in the week ended Jan. 8, will probably slow down by the middle of the year if municipal bonds remain cheap, researchers and analysts said.

Wells Fargo's Cohen pointed out that improving financial standings of stressed regions such as Puerto Rico and California will play a major part in municipal performance in 2014. Infrastructure deals and transportation issuers such as airports will remain a primary provider of bonds in 2014, analysts said.

"The muni market does tend to self-heal," Cohen said. "It's not as systemic as many think. You could have one school next to another, where one is doing fine and the other is in fiscal distress."


Oliver Renick is the sell-side reporter at The Bond Buyer.

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